THE  LIBRARY 

OF 

THE  UNIVERSITY 

OF  CALIFORNIA 


HENRY  RAND  HATFIELD 
MEMORIAL  COLLECTION 

PRESENTED  BY 

FRIENDS  IN  THE  ACCOUNTING 

PROFESSION 


C:      Y  C/^^ 


AUDITING 

THEORY  AND  PRACTICE 


By 
ROBERT  H.  MONTGOMERY,  C.P.A. 

of   Lybrand,    Ross  Brothers  and    Montgomery;    Attomey-at-Law; 

Professor  of  Accounting,   Columbia   University;  Former  President, 

American  Association  of   Public  Accountants;    author  of  "Income 

Tax  Procedure" 


THIRD  EDITION 
REVISED  AND  ENLARGED 


IN  TWO  VOLUMES 

VOLUME  I 
GENERAL  PRINCIPLES 


Third  Printing 

NEW  YORK 
THE  RONALD  PRESS  COMPANY 

1922 


Copyright  1912,  1915,  and  1921,  by 
Robert  H.  Montgomery 


Copyright  19 16,  by 
The  Ronald  Press  Company 


All  Rights  Reserved 


M7 


/9XI 

PREFACE  TO  THIRD  EDITION 

Since  the  publication  of  the  second  edition  of  this  book  in 
191 6,  the  fluctuations  in  financial  and  business  conditions  have 
been  more  violent  than  during  any  previous  five  years  in  the 
history  of  the  world.  We  have  had  unparalleled  inflation  and 
partial  deflation.  Tax  rates  have  been  so  high  that  nearly  seven- 
eighths  of  the  net  incomes  of  some  taxpayers  for  one  year  were 
paid  in  taxes.  Notwithstanding  the  extraordinary  tax  levies, 
the  annual  net  incomes  remaining  to  many  taxpayers  after  allow- 
ance for  taxes  exceeded  their  incomes  of  prior  years.  Some  con- 
cerns are  worse  off  financially  in  192 1  than  in  1916;  they  made 
large  paper  profits  and  distributed  only  a  small  portion  of  their 
realized  profits  in  dividends,  but  they  overexpanded  or  they  were 
not  prepared  for  the  rapid  fall  in  prices.  Conservative  concerns 
paid  relatively  higher  taxes  than  those  which  had  never  pursued 
conservative  policies. 

Professional  auditors  occupied  responsible,  arduous,  and  use- 
ful positions  throughout  the  five  years.  In  the  World  War  they 
were  found  in  the  trenches,  in  aeroplanes,  and  in  vessels  on  and 
under  the  water.  Those  who  were  not  allowed  to  fight  the  enemy . 
abroad,  fought  him  at  home.  The  war  was  won  in  more  ways 
than  one.  The  professional  auditor  did  his  duty  to  his  country 
and  to  his  profession.  The  profession  met  the  test  of  war  and 
inflation  and  has  tremendously  increased  in  prestige.  There  is 
no  longer  any  doubt  regarding  the  value  of  the  services  of  the 
professional  accountant. 

What  of  the  future?  Have  we  learned  anything?  Did  any 
of  our  theories  fail  in  application  at  critical  times?  An  inclusive 
answer  can  be  made.  In  serving  others,  accountants  have  served 
themselves.  The  future  is  bright  because  we  have  profited  by  our 
mistakes.  It  is  a  cause  for  congratulation  that  accountancy  is 
living  up  to  the  best  traditions  of  a  learned  profession  and  is 

iii 


^-^%  ji  ^  -^ 


IV  PREFACE 

discarding  obsolete  theories  and  substituting  new  ones  as  rapidly 
as  conditions  warrant. 

Naturally  there  are  some  statements  in  the  new  book 
which  conflict  with  cherished  and  long-thought-out  ideas  in  the 
old.  Perhaps  I  should  be  proud  to  say  that  I  have  changed  my 
mind  in  several  important  matters,  but  I  am  not  advanced  enough 
to  be  proud  of  it;  I  am  sorry,  rather,  that  we  must  change  some  of 
our  accounting  theories. 

We  are  more  sure  of  the  meaning  of  accounting  terminology. 
In  view  of  the  greatly  increased  use  of  the  term  *'good  accounting 
practice"  in  tax  laws,  legal  instruments,  and  business  agreements 
of  all  kinds,  I  have  attempted  to  define  the  term  as  applied  to 
many  different  situations.  My  definitions  are  not  inventions. 
Good  accounting  practice  is  merely  the  practice  of  good  account- 
ants. I  have  given  due  consideration  to  what  other  accountants 
are  doing  and  saying,  and  the  results  are  embodied  in  this  book. 

As  a  whole  this  book  purports  to  be  an  audit  program,  but  it 
is  general,  not  specific,  and  leaves  something  to  the  skill  and 
imagination  of  the  auditor.  When  a  professional  man  becomes 
too  technical,  too  specific,  he  falls  into  a  rut,  and  the  rut  retards 
and  cramps  his  professional  career.  It  is  imperative  that  financial 
statements  should  reflect  full  and  true  financial  conditions;  to  be 
full  they  must  be  flexible;  to  be  true  much  must  be  left  to  the 
experience,  skill,  and  discretion  of  the  auditor. 

I  am  not  satisfied  with  all  the  rules  that  govern  the  prepara- 
tion of  present-day  balance  sheets.  Conservatism  calls  for  writ- 
ing down  assets  when  market  values  fall,  and  leaving  assets  at 
cost  when  values  rise.  This  works  out  well  when  there  are  no 
rapid  or  radical  changes  in  market  conditions.  When  values 
fluctuate  widely,  however,  balance  sheets  do  not  reflect  the  ''full 
and  true  financial  position"  which  is  the  goal  of  the  auditor. 
When  the  market  is  advancing,  valuations  at  cost  by  no  means 
reflect  the  "  true  financial  position."  When  the  market  is  declin- 
ing, valuations  usually  are  too  high,  even  though  written  down  to 
market  at  date  of  the  balance  sheet. 


PREFACE  V 

If  auditors  in  their  discretion  fail  to  write  values  up  in  an  ad- 
vancing market,  why  does  not  sound  judgment  dictate  that  in  a 
period  of  steadily  declining  prices,  values  shall  be  written  down 
below  apparent  market  at  date  of  balance  sheet?  The  rule,  ^'  cost 
or  market,  whichever  is  lower,"  must  be  amplified  and  given  more 
flexible  application  in  times  when  the  trend  of  prices  is  sharply 
upward  or  downward.  I  have  exhaustively  discussed  these  points 
in  the  inventory  chapters. 

My  suggestion  is  that  when  reappraisals  or  inventories  at 
market  indicate  higher  values  than  cost,  the  appreciation  may  be 
expressed  in  the  balance  sheet  provided  the  increment  is  not  set 
up  as  realized.  I  am  not  sanctioning  the  practice  of  anticipating 
profits,  for  that  is  vicious.  Let  me  illustrate.  If  a  concern  buys 
or  produces  copper  at  lo  cents  a  pound,  which  at  the  date  of 
inventory  is  freely  selling  at  15  cents  a  pound,  and  the  market 
continues  to  rise  after  the  date  of  the  balance  sheet,  surely  no 
sound  accounting  or  economic  principle  is  being  violated  if  the 
market  value  as  well  as  cost  is  shown  in  the  balance  sheet.  To 
carry  copper  at  10  cents  because  cost  is  lower  than  market,  would 
be  positively  misleading  unless  the  additional  financial  resources 
of  the  concern  are  disclosed  somewhere  on  the  statement.  Like- 
wise, when  copper  costs  20  cents  and  at  the  date  of  balance  sheet 
is  selling  for  18  cents,  and  after  the  date  of  the  balance  sheet  has 
declined  still  further,  it  is  equally  deceptive  to  value  the  copper 
at  18  cents  merely  because  that  happened  to  be  the  market  price 
on  one  day. 

I  stand  always  for  conservatism  in  the  preparation  of  balance 
sheets,  but  I  do  not  like  to  see  business  men  deceive  themselves 
through  misrepresentation  of  financial  position.  I  would  not 
hesitate  to  cut  market  prices  to  a  level,  however  low,  that  would 
correspond  with  my  estimate  of  the  ultimate  drop. 

I  have  not  formulated  a  new  rule,  but  I  suggest  amplification 
of  the  old  rule  so  that  the  balance  sheet  may  more  nearly  reflect 
a  concern's  actual  financial  position  than  under  the  present  in- 
flexible rule. 


VI  PREFACE 

During  the  period  of  high  taxes  and  large  profits,  business 
men  required  no  urging  to  be  conservative.  During  the  next  few 
years  when  taxes  and  profits  are  likely  to  be  lower,  there  will  be 
little  incentive  to  conservatism,  with  the  result  that  auditors  will 
be  under  pressure  from  which  they  have  been  free  for  several 
years.  Their  actions  and  decisions  under  these  circumstances 
will  be  a  test  of  professional  standing;  those  who  yield  not  only 
will  damage  their  own  reputations,  but  will  prolong  the  financial 
stress  of  their  clients;  those  who  insist  on  the  maintenance  of  the 
highest  professional  standards  will  increase  their  own  prestige 
and  perform  substantial  service  to  their  clients. 

In  many  respects  this  is  a  new  book  rather  than  a  new  edition. 
It  deals  with  present-day  problems.  In  rewriting  the  part  relat- 
ing to  general  principles,  I  have  retained  much  of  the  old  text, 
because  it  is  not  obsolete.  There  are  about  two  hundred  pages  of 
new  text,  chiefly  containing  comments  on  valuations,  changes 
growing  out  of  the  war  and  post-war  influences,  other  balance 
sheet  matters,  references  to  specific  cases  of  interest,  and  defini- 
tions of  good  accounting  practice.  Under  the  circumstances,  it 
was  impracticable  to  include  any  comprehensive  discussion  of 
special  points  in  one  volume  of  reasonable  size;  therefore,  two 
volumes  became  necessary.  In  the  first  volume,  general  principles 
are  discussed;  the  second  volume  is  devoted  to  audit  procedures 
that  are  applicable  to  various  classes  of  business. 

It  has  been  suggested  that  the  second  edition  was  too  compre- 
hensive for  students.  I  realize  that  many  students  and  some 
instructors  are  anxious  and  willing  to  substitute  a  smattering  of 
the  subject  for  an  exhaustive  study,  but  happily  they  comprise  a 
small  minority. 

I  wish  to  express  my  appreciation  of  the  many  criticisms  and 
helpful  suggestions  made  by  my  partners,  William  M.  Lybrand, 
C.  P.  A.,  and  Walter  A.  Staub,  C.  P.  A.  Naturally  some  of  my 
comments  represent  personal  views  which  are  not  shared  by  all 
the  partners;  the  responsibiHty  for  the  book  is  mine  and  is  not 
shared  by  the  firm.    It  is,  however,  true  that  when  I  refer  to 


PREFACE  VU 

"good  accounting  practice/'  I  adopt  or  discuss  the  practice  of  all 
reputable  firms  whose  published  balance  sheets,  certificates,  re- 
ports, and  writing  have  been  available. 

Necessarily  much  of  my  work  was  done  at  irregular  intervals, 
which  meant  that  my  notes  required  careful  revision  and  arrange- 
ment. This  work  was  done  for  me  by  Professor  Earl  A. 
SaHers  of  Yale  University,  and  I  take  this  opportunity  to  express 
my  appreciation  of  his  able  and  conscientious  work. 

During  the  five  years  since  the  second  edition  was  issued,  I 
have  received  a  great  many  criticisms  and  suggestions  from 
readers  and  students.  In  most  instances,  I  have  responded 
promptly;  in  others,  absence  from  the  country  or  activity  in  war 
service  has  prevented  answers.  In  all  cases,  however,  I  greatly 
appreciate  comments  and  suggestions.  I  am  particularly  glad  to 
be  told  wherein  I  am  wrong. 


Robert  H.  Montgomery 


55  Liberty  St.,  New  York, 
November  5,  1921. 


CONTENTS 


Chapter  Page 

I    The  Auditor  and  His  Work 3 

Qualifications  of  the  Auditor 
Legal  Responsibility  of  Auditors 
Professional  Ethics 

II    The  Purposes  of  an  Audit .      18 

A  Constructive  Program 
The  Purposes  of  an  Audit 
The  Minor  Objects  of  an  Audit 

\ 

III  Advantages  of  an  Audit    .........      29 

Verification  of  Balance  Sheet 
Major  Advantages 

IV  How  TO  Begin  an  Audit 39 

A  Preliminary  Program 

The  Detailed  Audit 

Balance  Sheet  Audit 

Suggestions  to  Client's  Staff  before  Commencing  Work 

V    Audit  Procedure 60 

Program  of  Audit 

Papers,  etc.,  Required  by  Auditor 

System  of  Internal  Check 
Purpose  of  Internal  Check 
Branch  Office  Accounts 

VI    Balance  Sheet  Audit — Assets 71 

General  Principles 

Limitations  of  Balance  Sheet  Audits  Must  Be  Understood 

Analysis  of  Assets 

Basis  of  Valuation  of  Assets 

Current  Assets 

VII    Balance  Sheet  Audit — Current  Assets   ....      85 

Cash 

Accounts  Receivable 

Instalment  Accounts 

Export  Sales 

Deposits 

Verification  of  Outstandings  by  Correspondence 

Notes  Receivable 


X  CONTENTS 

Chai»ter  Page 

Accrued  Interest  Receivable 

Stock  Subscriptions 

Investment  Securities 

Securities  as  Stock-in- Trade 

Liberty  Bond  Valuations 

Insurance  on  Lives  of  Proprietors 

Temporary  Investments 

Postage  and  Other  Stamps 

Deferred  Charges  to  Operation — Prepaid  Items 

VIII    Inventories — General  Principles 117 

Introductory 

Need  of  Understandable  Rule  of  Valuation 

Valuation  Propositions  to  Be  Considered 

1.  When  Is  It  Proper  to  Value  Inventories  at  Less  Than 

Either  Cost  or  Market? 

2.  When  Is  It  Proper  to  Value  an  Inventory  at  "Cost  or 

Market,  Whichever  Is  Lower"? 

3.  When  Is  It  Proper  to  Value  an  Inventory  at  Reproduc- 

tion Cost,  It  Being  Higher  Than  Replacement  Cost? 

4.  When  Is  It  Proper  to  Value  an  Inventory  at  Market, 

Market  Being  Higher  than  Cost? 

5.  When  Is  It  Proper  to  Value  an  Inventory  at  Selling 

Prices? 
Prices  After  Closing  Date 
Interdepartmental  or  Intercompany  Profits 
Segregation  of  Stock  Which  Cannot  Be  Converted  into  Cash 

Within  One  Year 
Auditor's  Legal  Duty  as  to  Inventories 
Interest  Not  an  Element  of  Cost 

IX    Inventories — Rules  for  Valuation     .....     159 

Proper  Rule  for  Valuation 

Rules  for  Verifying  Quantities  and  Other  Factors 

Goods  in  Process 

Finished  Goods 

Supplies,  Stores,  etc. 

X    Balance  Sheet  Audit — Fixed  Assets 173 

Nature  of  Fixed  Assets 

Plant  Accounts  Must  Be  Analyzed 

Methods  of  Arriving  at  Balance  Sheet  Valuations 

Land  and  Buildings 

Leaseholds 

Machinery  and  Equipment 

Furniture  and  Fixtures 

Containers 

Horses 

Wagons,  Automobiles,  etc. 

Patterns,  Drawings,  Lasts,  etc. 

Electrotypes,  Woodcuts,  etc. 


CONTENTS  XI 

Chapter  Page 

Patents 
Copyrights 

XI    Balance  Sheet  Audit — Fixed  Assets  (Continued)      .     195 

Good-Will 

Earnings  the  Principal  Factor  of  Value 
Formula  for  Determining  Value 

Fund  Accounts 

Sinking  Funds 

Funds  Representing  Investments  of  Reserves 
Fund  and  Other  Permanent  Investments 
Bonds  and  Mortgages 

Treasury  Stock 
Unissued  Capital  Stock 

Wasting  Assets  • 

Values  to  Be  Written  Down 

Contingent  Assets 
Capital  Stock  Calls  and  Assessments 
Liabilities  of  Directors 

Secret  Reserves 
How  Secret  Reserves  Are  Created 

XII    Balance  Sheet  Audit — Liabilities       ...  .221 

Information  Bankers  Require 

Position  of  Auditors 

Determination  of  Liabilities 

Distinction  Between  Liabilities  and  Capital 

Accounts  Payable 

Trade  Creditors 

Liabilities  for  Goods  Received  on  Consignment 

Notes  Payable 

Mortgages 

Bonds 

Rules  Which  Govern  Loans 

Judgments 

Interest  Payable 

Taxes 

Water  Rates,  etc. 

Insurance 

Wages 

Rent 

Freight 

Traveling  Expenses  and  Commissions 

Legal  Expenses 

Audit  Fees 

Employees'  Profit-Sharing  Plans 

Damages  and  Other  Unliquidated  Claims 

Coupons,  Unused  Tickets,  etc. 

Deposits 

Unclaimed  Dividends 


Xll  CONTENTS 

Chapter  Page 

XIII  Balance  Sheet  Audit — Contingent  Liabilities    .     .     247 

Contingent  Liabilities  Defined 

Liabilities  Created  After  Date  of  Balance  Sheet 

Notes  Receivable  Discounted 

Indorsements 

Guarantees,  Suretyship 

Acceptances 

Capital  Stock  Convertible  into  Bonds 

Unfulfilled  Contracts 

Bond,  Note,  and  Preferred  Stock  Stipulations 

The  Minute  Book 

XIV  Balance  Sheet  Audit — Reserves,  Capital,  and  Sur- 

plus   267 

Reserves 
Capital  Stock 
Balance  Sheet  Construction 
Audit  Procedure 
No-Par  Value  Stock 

Restrictions  Affecting  Transfers  of  Capital  Stock 
Stock  Dividends 
Premiums  on  Capital  Stock 

Surplus 
Reserves  for  Retirement  of  Securities 
Reserve  for  Working  Capital 
Reserves  for  Dividends 
Investment  of  Surplus 

XV    The  Income  Account   .     .     .     .     .     .     .     .     .     .     290 

Capital  and  Income 

Form  of  Income  Account 
^       Proceeds  of  Sale  of  Treasury  Stock 

Dividends  Must  Not  Be  Paid  from  Capital 
Wasting  Assets 
Decedents'  Estates 

Importance  of  Uniform  Terminology  in  the  Income  Ac- 
count 
Importance  of  Income  Account 
Relation  of  Net  Income  to  Price-Fixing 
Legal  Definition  of  Net  Income 
Economic  Definition  of  Net  Income 
Accountant's  Definition  of  Net  Income 

XVI    The  Income  Account— Revenues 311 

Gross  Income 

Returns 

Sales  of  Consigned  Goods 

Ordinary  Transactions  Only  to  Be  Included 

Allowances  and  Rebates 


CONTENTS 


xin 


Chapter 

Doubtful  Accounts 

Income  from  Work  in  Progress 

Departmental  Profits 

Intercompany  Profits 

Income  from  Sales  for  Future  Delivery 

Participations  and  Underwritings 

Income  Arising  from  Sale  of  Capital  Assets 

Income  from  Royalties 

Appreciation  in  Value  of  Assets 

XVII    The  Income  Account — Expenses  and  Losses 

Reserves 
Depreciation 
Obsolescence 
Accrued  Expenses,  etc. 
Trade  Discounts 
Cash  Discounts 

Disposition  of  Net  Income 
Dividends 
Position  to  Be  Taken  by  Auditor 


Page 


324 


XVIII    Consolidated  Balance  Sheets  AND  Income  Accounts    335 

Definition  of  "Subsidiar^^" 

Balance  Sheets  of  Holding  Companies 
Importance  of  Correct  Statement — Rediscounts 
Form  of  Balance  Sheet 
Records  in  Books  of  Account 
Guarantees  of  Subsidiaries'  ObHgations 

Income  Account 
Comparative  Statements 

XIX    Certificates  and  Reports 352 

Something  More  Than  Figures  Are  Wanted  in  a  Report 

Terminology 

Scope  of  Report 

Certificate  of  Audit 

Form  of  Balance  Sheet 

Statement  Required  by  Banks 

New    York    Stock    Exchange    Requirements    for    Listing 

Securities 
Federal  Reserve  Board  Requirements 
Statements  Requested  by  Credit  Managers 
Forms  Issued  by  Mercantile  Agencies 


XX    Certificates  and  Reports  (Continued) 

Liens  and  Hypothecations 
Forms  of  Income  Account 


405 


xiy 


CONTENTS 


Chapter 


Page 


Graphic  Charts 
Use  of  Charts  and  Graphs 
Essentials  of  a  Good  Chart 
Types  of  Charts 
Circle  Type 
Bar  Type 

Broken  Line  or  Curve  Type 
Value  of  Comparative  Statistics 
What  Not  to  Report 
Restrictions  on  Ghent's  Use  of  Reports 
Misleading  Advertisements 
Compulsory  Reports 


XXI    Investigations 423 

Scope  of  the  Work 

Instructions  from  Clients 
Working  Papers  to  Be  Preserved 
Detail  Which  May  Be  Omitted 
Previous  Audits 
Where  Assets  Are  Appraised 
Definite  Report  Wanted 
Handling  Books  and  Records 
False  Entries  Sometimes  Forgeries 
The  Auditor  as  an  Expert  Witness 

On  Sale  or  Purchase  of  a  Business 

(a)  Requirements 

(b)  Period  Covered 

(c)  Analysis  of  Earnings  and  Expenses 

(d)  Future  Requirements  and  Economies 

(e)  System  of  Accounts 

(f )  Elimination  of  Unusual  Items 

(g)  Adjustments  and  Qualifications 
(h)  Errors  in  the  Books 

(i)    Investigation  on  Behalf  of  a  Retiring  Partner  When 
the  Business  Is  Being  Sold  to  a  Continuing  Partner 
(j)    Investigation  for  Those  in  Charge  of  Reorganizations 


XXII    Investigations  (Concluded) 470 

Investigation  on  Behalf  of  a  Present 
OR  Prospective  Creditor 

(a)  Examinations  for  Bankers 

(b)  Investigations  After  Bankruptcy 

(c)  Investigation  for  Purely  Credit  Purposes 

(d)  Investigation  in  Patent  Litigation 

Fraud 

Possibilities  to  Be  Studied 

Extent  of  Fraud 

Attitude  Toward  an  Embezzler 

Definitions 


CONTENTS 


XV 


Chapter 
XXIII    The  Detailed  Audit 


Page 
491 


General  Principles 
Completed  Audit 
Continuous  Audit 
Auditing  by  Tests  and  Scrutiny 

The  Audit  of  Earnings  and  Expenses 
General  Principles 
Prior  Periods 
The  Accrual  Method 
Verification  of  Footings  and  Postings 

1.  Purchase  Records 

2.  Sales  Records 

3.  Cheques  Received  Must  Be  Deposited 

4.  Periodical  Verification  of  Bank  Balances 

5.  Cash  Receipts 

6.  Cash  Payments 

7.  Other  Records  * 


XXIV    The  Detailed  Audit — Verification  of  Income 

Fraud  Connected  with  Receipts 

Sales 
Importance  of  Original  Records 
Orders  for  Future  Delivery 
Consignments  and  Goods  Out  on 
Goods  Received  for  Sale 
Sales  Not  Delivered 
Cash  Discounts 
Collections  Not  Accounted  for 
Confirmations  of  Outstandings 


515 


Memorandum" 


Income  from 
Interest  Receivable 
Rents  Receivable 


Investments 


Miscellaneous  Income 

Discount  for  Prepayment 

Realizations  from  Items  Previously  Charged  to  Income 

Sales  of  Building  Lots 

Services  and  Other  Charges  Billed  in  Advance 

Income  from  Corporation's  Own  Issues 


XXV    The  Detailed  Audit — Purchases  and  Expenses  .     .     538 

Vouchers 
Procedure 

Paid  Cheques  as  Evidence 
Purchase  Invoices 
Internal  Check 
What  Vouchers  to  Examine 


XVI:  CONTENTS 

Chapter  Page 

Irish  Woolen  Mill  Case 

Missing  Vouchers 

Vouchers  for  Petty  Cash  Payments,  Pay-Roll,  etc. 

Journal  Vouchers 

Cancellation  of  Vouchers. 

Miscellaneous  Expenditures 

Repairs  and  Renewals 

Allowances  and  Returns 

Containers 

Salaries 

Salesmen's  Commissions 

Traveling  Expenses,  Entertaining,  etc. 

Wages 

Customs  Duties 

Interest  and  Collection  Charges 

Insurance  Premiums 

Freight  and  Express 

Postage 

Legal  Expenses  and  "Graft" 

Deferred  Charges 

Allocation  of  Costs  and  Expenses 
Doubtful  Deferred  Charges 
Organization  Expenses 


XXVI    The  Detailed  Audit  (Concluded) 578 

The  Trial  Balance 

Outstanding  Accounts 
Bad  or  Doubtful  Accounts 

Asset  and  Liability  Items 

Notes  Receivable 

Notes  Receivable  Protested 

Inventories 

Premiums  and  Discounts  on  Bonds  to  Be  Amortized 

Premiums  on  Capital  Stock 

Premium  on  Redeemable  Preferred  Stock 

Branch  Accounts 

Capital  Expenditure 

Cash  Discounts  on  Capital  Payments 

Real  Estate 

Buildings 

Improvements  and  Extensions 

Machinery,  etc. 

Notes  Payable 

Partners'  Withdrawals 

Dividends 

Capital  Stock 

Bonds 

Taxes 


CONTENTS 


xvu 


Chapter 

XXVII    Office  and  Accounting  Methods     .     .     .     .     . 

Office  Methods 

Styles  of  Books  and  Records 

Books  as  Evidence 

Loose- Leaf  Records 

Erasures 

Original  Records  Necessary 

Mechanical  Devices  as  an  Aid  to  the  Auditor 

Work  Which  May  Be  Done  with  the  Aid  of  Mechanical 

Devices 
Filing  Systems 
Copying 

Mailing  Department 
Stock  on  Hand 

Controlling  Subsidiary  Ledgers 
Columnar  Ledgers 
Efficiency  of  Organization 


Page 
600 


XXVIII    Depreciation 


621 


Causes  of  Depreciation 

Repairs  and  Maintenance 

Methods  of  Applying  Depreciation  in  the  Books 

Sinking  Fund  Requirements  to  Retire  Bonds,  etc. 

Not  Be  Confused  with  Depreciation  Allowances 
Cost  the  Proper  Basis 
Depreciation  Is  an  Operating  Expense 
Depreciation  a  Local  Issue 
Investment  of  Depreciation  Reserves 
Importance  of  Provision  for  Obsolescence 
Depreciation  of  Different  Classes  of  Property 
Land 
Buildings 
Leaseholds 

Machinery  and  Equipment 
Small  Tools 
Furniture  and  Fixtures 
Landlord's  Fixtures 
Horses 

Wagons,  Automobiles,  etc. 
Ships 
Patents 
Good-Will 
Wasting  Assets 
Timber  Lands 


Must 


XXIX    Interest ....     655 

Principal 

Rate  of  Interest 

Time 

The  Unit  Period 


XVlll  CONTENTS 

Chapter  Page 

XXX    The  Liabilities  of  Directors 665 

Board  Minutes'  Inspection 
Directors'  Dealings  with  Company 
Personal  Liability  of  Directors 
Compensation  of  Directors 
Directors  May  Inspect  Books 
Legal  Liabilities  of  Directors 

Appendix  A — Uniform  Accounting .     679 

B — Example  of  Provisions  Contained  in  a  Preferred 

Stock  Agreement 706 

» 

FORMS  AND.  CHARTS 


Charts  Showing  Computation  of  Good-Will 199 

Forms  of  Balance  Sheets 367-369,  375 

Federal  Reserve  Board  Form  of  Balance  Sheet 372-373 

Information  Blank — American  Bankers'  Association  Form     .      .      .  378-380 
'*               "     — Irving  National  Bank  of  New  York        .      .      .  382-385 
Federal  Reserve  Board  Form  of  Financial  Statement  for  Manufactur- 
ing or  Mercantile  Business — Corporation 387-388 

Federal  Reserve  Board  Form  of  Financial  Statement  for  Manufactur- 
ing or  Mercantile  Business — Partnership  or  Individual        .      .      ,  389-390 
Federal  Reserve  Board  Form  of  Financial  Statement — Farmer  or 

Other  Individual 391-392 

National  Association  of  Credit  Men's  Form  of  Financial  Statement  .  395-396 
The  Bradstreet  Company's  Form  of  Financial  Statement.  .  .  .  398-401 
R.  G.  Dun  and  Company's  Form  of  Financial  Statement       .      ,      .  '402-404 

Condensed  Income  Account 407 

Condensed  Profit  and  Loss  Statement 408 

Graphic  Chart — Circle  Type 411 

"     — Bar  Type 413 

"  "     — Broken  Line  or  Curve  Type 414-415 

Comparative  Income  Statement 440-441 

Federal  Reserve  Board  Form  of  Profit  and  Loss  Account       .      .      .  704-705 


AUDITING 
THEORY  AND  PRACTICE 


VOLUME  I 
GENERAL  PRINCIPLES 


CHAPTER  I 

THE  AUDITOR  AND  HIS  WORK 

The  purpose  of  this  book  is  to  set  forth  the  principles  under- 
lying the  theory  and  practice  of  auditing  and  to  outline  the  work 
which  must  be  done  in  whole  or  in  part  in  any  audit.  These  prin- 
ciples embrace  the  fundamentals  of  business  and  finance;  and  the 
discussions,  particularly  of  disputed  questions,  which  are  neces- 
sary to  bring  out  the  truth  and  to  settle  the  standards  of  good 
accounting  practice  are  of  interest  to  those  who  do  not,  as  well  as 
to  those  who  do,  expect  to  engage  in  the  actual  work  of  an  audit. 

Qualifications  of  the  Auditor 

An  ideal  audit  cannot  be  made  without  a  full  perspective  of 
the  science  of  accounts,  for  many  who  have  a  good  working 
knowledge  of  the  details  of  practical  accounting  find  it  difficult  to 
visualize,  as  it  were,  the  records  of  business  transactions. 

Analytical  Ability. — The  auditor  who  best  accomplishes 
his  task  is  he  who  is  able  to  put  himself  in  the  place  of  those  for 
whom  the  accounts  are  intended.  He  will  not  find  this  easy 
unless  he  has  been  trained  to  make  the  most  of  the  figures  which 
appear  in  a  balance  sheet  or  income  statement.  To  present 
correct  accounts  is  not  enough,  because  correct  accounts  may  not 
be  clear  to  those  for  whom  they  are  intended.  A  scientific  system 
of  accounts  is  a  method  whereby  a  graphic  and  intelligent  record 
of  facts  may  be  assembled  and  by  logical  processes  reduced  to 
readable  form. 

Constructive  Ability. — Auditing  is  the  analytical,  as 
practical  accounting  is  the  constructive,  branch  of  accountancy; 
but  the  modern  auditor  is  more  than  an  analyst.  The  logical 
development  of  his  profession  and  the  increased  appreciation  of 

3 


4  AUDITING— GENERAL  PRINCIPLES 

the  value  of  his  work  have  added  to  his  former  duties  certain 
constructive  functions  which  must  be  fulfilled  in  connection  with 
a  large  proportion  of  his  engagements. 

It  has  been  suggested  that  accountants  or  auditors,  to  be  of 
real  value  to  their  cHents,  must  go  so  far  afield  as  to  make  a  study 
of  the  elements  of  labor  direction  and  of  production,  among  other 
things.  Too  often  it  has  been  urged  that  the  average  accountant 
has  the  mind  of  a  bookkeeper,  whose  prime  object  is  to  balance 
accounts.  A  balance  sheet  merely  shows  results  and  cannot  be 
fully  imderstood  or  used  unless  what  is  back  of  the  figures  is  in- 
telHgently  studied.  The  study,  however,  must  be  orderly  as  well 
as  intelHgent.  In  the  following  pages  an  attempt  is  made  to 
suggest  what  must  be  done  in  every  case  when  a  true  balance 
sheet  and  income  statement  are  desired. 

Ability  to  Explain  Facts. — The  average  business  man  has 
been  trained  from  boyhood  to  read  facts  and  figures  from  con- 
tinuous printed  pages.  The  trial  balance  of  a  ledger  means 
nothing  to  him,  except  that  part  of  it  which  contains  the  accounts 
receivable  and  payable,  and  these  must  not  be  called  ^^ debit 
balances"  or  ''credit  balances"  if  we  would  avoid  the  chance  of 
being  misunderstood. 

Many  intelligent  people  fail  to  grasp  the  usual  and  conven- 
tional hypothesis  underlying  the  theory  of  double-entry  book- 
keeping; important  facts  or  figures  presented  to  them  in  a 
technical  or  formal  shape  may  not  accomplish  the  intended  result. 
Therefore,  the  study  of  auditing  is  essential  to  those  who  desire 
to  study  business.  It  forces  training  in  the  fundamental  essen- 
tials of  every  business.  It  also  enables  a  business  man  to  know 
whether  an  auditor  whom  he  may  later  employ  is  doing  his  work 
properly. 

Probably  the  majority  of  business  men  have  been  shown  trial 
balances  from  their  books  which  mean  nothing  to  them.  This 
applies  to  the  usual  monthly  balance  as  well  as  to  the  one  made 
after  closing  the  books.    A  balance  sheet  in  conventional  form  is 


THE  AUDITOR  AND  HIS  WORK  5 

perfectly  clear  to  the  eye  which  is  trained  to  read  and  understand 
figures,  and  is,  perhaps,  as  concise  and  satisfactory  an  exhibit  as 
could  be  desired  for  the  person  who  understands  figures;  but  thou- 
sands of  business  men  frankly  acknowledge  that  they  do  not  grasp 
the  full  import  of  a  financial  statement  in  the  accepted  form. 

But  if  the  man  who  is  entitled  to  know  all  the  facts  contained 
in  these  balance  sheets  cannot  or  will  not  understand  this  method 
of  presentation,  is  it  not  our  duty  to  try  another  form  and  keep 
on  trying  until  the  results  of  his  business  become  as  interesting 
reading  to  him  as  the  daily  trade  reports?  If  the  client  had  his 
own  way  he  would  ask  for  a  report  on  his  business  prepared  so 
that  he  could  read  it. 

This  is  the  point  of  view  to  which  every  accountant  must 
direct  his  attention  imtil  he  can  so  connect  figures  and  trans- 
actions that  an  audit  will  no  longer  mean  a  mere  verification  of 
the  figures  in  the  books,  but  will  include  a  lively  appreciation  of 
every  ramification  of  the  business.  In  other  words,  the  auditor 
must  visualize  the  transactions  themselves  to  see  that  their  con- 
version into  dollars  and  cents  is  reflected  in  the  books  of  account. 

The  proprietor  knows  intuitively  all  of  the  possible  functions 
of  his  business;  the  auditor  may  not  know  them  intuitively,  but 
he  must  ascertain  how  and  why  the  proprietor  looks  at  the  busi- 
ness as  he  does,  otherwise  there  will  be  no  meeting  of  the  minds  of 
the  auditor  and  his  client.  Without  a  complete  understanding  of 
each  other's  point  of  view,  ideal  professional  relations  can  never 
be  maintained. 

Experience  and  Training. — There  are  many  ramifications 
of  business  affairs  which  cannot  be  understood  without  more  or 
less  actual  experience  and  technical  training,  and  which  therefore 
cannot  be  satisfactorily  elucidated  within  the  limits  of  one  book; 
but  it  is  the  firm  belief  of  the  author  that  a  common-sense  knowl- 
edge of  bookkeeping  and  a  general  acquaintance  with  business 
affairs  are  the  most  necessary  foundation  of  the  student  of 
auditing. 


6  AUDITING— GENERAL  PRINCIPLES 

It  is  not  to  be  expected  that  a  clerk  with  a  Httle  knowledge  of 
accounts  or  a  business  man  with  no  practical  experience  in  other 
lines  than  his  own,  can  by  a  mere  reading  of  these  pages  acquire 
at  once  the  skill  necessary  for  the  professional  accountant. 
Nevertheless,  this  book  is  intended  for  the  instruction  of  those 
possessing  but  httle  experience  as  well  as  for  the  guidance  of  the 
quahfied  pubHc  accountant.  Accountancy  is  a  science,  and  it 
should  be  possible  to  present  its  underlying  principles  so  that  they 
may  be  comprehensible  to  the  average  mind.  Theory  alone, 
however,  never  qualifies  anyone  to  practice  as  a  public  accountant 
any  more  than  a  medical  student  is  quahfied  to  practice  medicine, 
no  matter  how  thorough  a  knowledge  of  the  science  of  medicine  he 
may  have  acquired  through  lectures  and  books,  unless  he  has  had 
an  opportunity  to  verify  his  book  knowledge  and  demonstrate 
his  skill  in  the  hospital  and  the  clinic. 

If  anyone  who  proposes  to  take  up  the  study  of  auditing  has 
not  had  a  fairly  thorough  training  in  bookkeeping,  and  in  addition 
has  not  had  sufficient  practical  experience  in  business  affairs  to 
enable  him  to  keep  his  poise  when  he  is  required  to  think  and  act 
quickly,  he  had  better  postpone  his  course  imtil  he  has  acquired 
enough  experience  to  lay  the  necessary  foundation.  It  is  absurd 
for  any  student  to  take  it  for  granted  that  a  good  memory  applied 
to  a  book  on  auditing  will  make  him  a  good  auditor. 

The  work  of  the  auditor  engaged  in  public  practice  is  impor- 
tant enough  to  raise  this  work  to  the  dignity  of  a  profession.  It 
has  been  called  the  profession  of  business  advice.  Someone  has 
defined  a  profession  as  a  calling  which  demands  of  its  members  a 
high  order  of  intellectual  attainment,  which  can  be  acquired  only 
by  long  and  arduous  preliminary  training. 

The  man  who  expects  to  make  a  success  as  a  public  accoun- 
tant must  cultivate  what  has  been  termed  ''professional  bearing." 
The  expression,  ''professional  bearing,"  is  an  inclusive  term 
comprising  such  matters  as  neat  and  unobtrusive  wearing  apparel 
and  dignified  demeanor.  It  means  courtesy  in  dealing  with  every- 
one, but  excessive  familiarity  with  none.    It  also  includes  the 


THE  AUDITOR  AND  HIS  WORK  7 

exercise  of  the  greatest  discretion  in  remarks  made  relative  to  the 
affairs  of  chents  and  the  assumption  of  an  impartial  unbiased 
attitude  until  all  the  facts  in  a  particular  situation  are  known. 

Legal  Responsibility  of  Auditors 

In  every  profession  there  are  some  incompetent  men  and  also 
a  certain  number,  fortunately  a  limited  number,  of  unreliable 
men.  The  process  of  weeding  out  such  members  of  the  profession 
is  difficult  but  it  is  necessary  if  the  professional  standard  is  to  be 
maintained  or  improved.  In  the  author's  opinion,  one  way  to 
eliminate  such  men  from  practice  would  be  to  make  them  fully 
appreciate  the  civil  responsibihties  of  a  professional  accountant. 
An  incompetent  man  would  hesitate  to  undertake  important 
engagements  if  he  were  aware  that  failure  to  do  the  work  properly 
might  involve  him  in  serious  loss.  The  unreliable  man  is  not  apt 
to  be  deterred  from  any  undertaking  except  by  fear  of  punish- 
ment, and  it  is  essential,  therefore,  that  he  also  should  understand 
well  that  he  is  not  free  from  civil  responsibility;  but  until  the 
American  courts  lay  down  specific  rules  regarding  the  duties  and 
obligations  of  pubKc  accountants,  it  is  to  be  feared  that  the 
spectre  of  legal  responsibility  will  not  act  as  a  deterring  factor  in 
the  case  of  either  incompetent  or  unreliable  men.  For  the  sake 
of  the  profession,  therefore,  it  is  desirable  that  such  duties  and 
obHgations  should  be  given  a  legal  definition  or  decision,  as  it 
would  result  in  the  raising  of  the  professional  standard  by  the 
elimination  or  restraint  of  those  who  do  faulty  or  fraudulent 
work.  Such  work  on  the  part  of  a  few  undesirable  men  is  apt  to 
be  given  such  notoriety  that  it  far  offsets  the  good  work  of  ten 
times  their  number. 

Trend  of  Legal  Decisions. — There  are  numerous  English 
decisions  dealing  with  the  rights  and  liabilities  of  professional 
auditors.  In  view,  however,  of  the  total  number  of  accountants  in 
practice  and  the  period  which  the  decisions  cover,  the  number 
of  these  decisions  does  not  seem  appalling.    While  the  fact 


8  AUDITING— GENERAL  PRINCIPLES 

that  we  have  only  a  few  reported  decisions  speaks  well  for 
the  integrity  and  good  judgment  of  our  accountants,  yet  it  is 
believed  that  other  occasions  have  arisen  where  litigation  would 
have  been  resorted  to  had  it  not  been  known  that  judgments 
involving  money  damages  would  have  been  worthless  so  far  as 
the  possibihty  of  collection  was  concerned. 

It  is  unfortunate  that  anyone  should  be  permitted  to  practice 
as  a  pubHc  accountant  who,  in  case  of  gross  negligence  or  mal- 
practice, has  so  little  financial  responsibility  that  a  judgment 
against  him  would  be  worthless,  and  who,  moreover,  is  beyond 
the  legal  reach  of  his  fellow  practitioners,  who  at  present  have 
no  opportunity  to  prefer  charges  against  one  who  is  neither  a 
member  of  the  national  or  a  state  society  nor  certified  by  a  state 
board. 

The  cases  decided  uphold  the  principle  of  law  that  anyone 
who  holds  himself  out  to  be  skilful  in  any  trade  or  profession,  and 
who  is  negligent  in  the  performance  of  what  he  undertakes, 
becomes  responsible  in  damages  for  such  failure.  This  civil 
responsibility  is  settled  and  cannot  be  debated,  but  it  should  not 
be  passed  over  lightly  and  should  be  emphasized  on  all  occasions. 
The  measure  of  legal  responsibility,  however,  is  much  too  low  for 
a  conscientious  accountant.  The  law  requires  of  him  only  the 
skill  of  an  ordinarily  skilful  accountant;  the  law  gives  him  the 
privilege  of  assuming  the  accuracy  of  many  things  unless  he  has 
definite  suspicions  to  the  contrary;  and,  as  already  stated,  the 
law  never  requires  one  to  measure  up  to  the  standard  of  the  most 
skilful  in  the  same  profession  or  trade.  In  this  respect  accoun- 
tants are  to  be  congratulated,  for  it  is  common  knowledge  that 
the  majority  of  professional  accountants  in  the  United  States 
seek  to  do  more  for  their  clients  than  the  law  requires,  and  every 
year  witnesses  a  more  general  desire  to  improve  the  quality  of 
services  rendered. 

It  is  earnestly  hoped  that  further  progress  will  be  made  in  this 
direction.  Since  the  wish  for  high  standards  is  general,  let  each 
individual  accountant  do  his  part  toward  maintaining  them. 


THE  AUDITOR  AND  HIS  WORK  9 

Public  opinion  should  be  aroused  so  that  unqualified  practitioners 
will  gradually  cease  to  practice,  and  in  their  place  a  united  body 
will  control  all  accountancy  matters — not  because  the  law  grants 
them  exclusive  privileges,  but  by  reason  of  the  fact  that  they  can 
be  depended  upon  at  all  times  and  under  all  circumstances,  while 
the  others  cannot. 

The  common  and  statutory  laws  of  Great  Britain  are  prolific 
in  decisions  and  enactments,  prescribing  with  much  exactness  the 
precise  nature  of  the  liabilities  which  an  auditor  may  conceivably 
incur  while  in  the  exercise  of  the  multifarious  activities  incident 
to  his  profession. ' 

It  is  highly  probable  that  in  the  event  of  any  litigation  of 
importance  occurring  here  and  involving  that  question,  the  courts 
of  America  will  look  to  the  English  cases  as  affording,  if  not  bind- 
ing precedents,  at  least  valuable  guides  to  the  considerations  and 
principles  of  law  appHcable  in  such  case. 

Summary  of  Decisions.— Based  upon  the  English  decisions 
and  upon  the  principles  of  the  common  law  in  force  in  the  United 
States,  the  professional  auditor's  legal  duties  and  Habilities  may 
be  summarized  as  follows : 

1 .  Anyone  who  holds  himself  out  as  skilled  in  a  profession  is 
charged  with  a  higher  degree  of  responsibihty  than  one  who  is 
inexperienced  and  who  does  not  seek  professional  work.  Acting 
in  a  professional  capacity,  an  auditor  must  do  more  than  ascertain 
the  mere  arithmetical  accuracy  of  the  accounts.  If  the  accounts 
do  not  represent  the  true  financial  position  of  the  undertaking 
under  examination,  and  if  that  fact  is  apparent  or  can  reasonably 
be  deduced  from  the  face  of  the  accounts  themselves,  then  the 
auditor  is  under  a  legal  obligation  to  discover  and  disclose  the 
true  state  of  affairs. 

2.  The  auditor,  however,  is  not  an  insurer  unless  he  assumes 
such  a  position.    If  he  uses  reasonable  care — the  care  of  an  ordi- 


'  For  English  cases  bearing  on  the  liabiHties  of  auditors,  refer  to  Auditing — 
Theory  and  Practice,  first  edition. 


lO  AUDITING— GENERAL  PRINCIPLES 

narily  skilful  auditor,  under  the  circumstances  of  the  case — ^no 
legal  responsibility  is  incurred  by  him. 

3.  Reasonable  care  has  been  stated  by  the  courts  to  depend 
upon  the  circumstances  of  each  case.  Where  there  is  no  reason- 
able ground  for  suspicion  of  fraud,  it  is  not  necessary  to  take  as 
many  precautions  as  are  requisite  where  the  auditor  is  led  to 
beheve  that  irregularities  exist. 

4.  Ordinarily  what  is  known  as  a  ''test  and  scrutiny"  audit  is 
sufficient,  but  in  every  case  there  must  be  a  careful  survey  of  the 
assets,  HabiUties,  income,  and  expenses,  in  order  that  the  auditor 
may  satisfy  himself  that  the  assets  and  the  income  are  accounted 
for,  and  that  the  Habilities  and  expenses  are  properly  supported. 
The  auditor  need  not  verify  every  item,  but  he  must  not  omit 
any  part  of  an  audit  which  the  custom  of  the  profession  decrees 
should  be  covered. 

5.  The  experience  of  other  practitioners  and  access  to  recog- 
nized authorities  on  the  subject  being  available,  a  defense  of 
ignorance  of  what  is  required  in  an  audit  will  not  save  an 
auditor  from  responsibihty  for  failure  to  follow  settled  rules  of 
practice. 

6.  The  general  rule  of  the  common  law,  that  all  men  are 
considered  honest  until  proved  dishonest,  may  be  observed  by  an 
auditor  with  respect  to  the  staff  of  the  client;  but  he  is  charged 
with  an  exceptional  degree  of  diligence  in  recognizing  indications 
of  dishonesty  on  the  part  of  those  who  occupy  responsible  posi- 
tions. 

7.  An  auditor's  relation  to  his  cHent  is  in  the  highest  degree 
confidential,  and  he  has  no  legal  right  to  communicate  with  third 
parties  (debtors  or  creditors)  unless  he  secures  permission  to  do 
so.  If  his  position  as  auditor  becomes  incompatible  with  honesty, 
he  may  withdraw  at  any  time,  but  he  is  not  at  Hberty  to  disclose 
to  outsiders  the  cause  of  his  withdrawal. 

8.  In  communicating  with  his  chent,  however,  the  auditor 
is  bound  to  disclose  information  (other  than  information  which 
has  been  received  in  confidence),  of  whatever  nature  it  may  be, 


THE  AUDITOR  AND  HIS  WORK  II 

which  is  of  value  to  the  client,  and  any  suppression  of  material 
facts  is  at  his  own  risk. 

9.  In  the  event  of  loss  through  an  auditor's  negligence,  the 
client  may  recover  damages  against  him.  The  measure  of 
damages  is  the  amount  which  the  client  or  other  interested  party 
has  lost  as  a  legal  consequence  of  the  auditor's  failure  to  perform 
his  duty  properly. 

American  Decisions. — In  one  American  decision,^  in  which 
a  mimicipahty  endeavored  to  recover  from  the  public  accountants 
the  amount  of  its  loss  through  a  defalcation  which  was  not  dis- 
closed by  their  audit  of  the  accounts,  the  court's  opinion,  in  part, 
reads  as  follows: 

Defendants  represented  themselves  as  expert  accountants,  which 
implied  that  they  were  skilled  in  that  class  of  work.  In  accepting  employ- 
ment as  expert  accountants,  they  undertook,  and  the  plaintiff  had  the  right 
to  expect,  that  in  the  performance  of  their  duties  they  would  exercise  the 
average  ability  and  skill  of  those  engaged  in  that  branch  of  skilled  labor. 
They  were  employed  to  ascertain,  among  other  things,  whether  any  ir- 
regularities had  occurred  in  the  financial  transactions  of  the  city  clerk, 
and,  if  so,  the  nature  and  extent  of  such  irregularities.  If,  from  want  of 
proper  skill,  or  from  negligence,  they  did  not  disclose  the  true  situation, 
they  failed  to  perform  the  duty  which  they  had  assumed,  and  failed  to 
earn  the  compensation  which  plaintiff  had  agreed  to  pay  them  for  the 
proper  performance  of  such  duty.  The  work  of  an  expert  accountant  is  of 
such  technical  character  and  requires  such  peculiar  skill  that  the  ordinary 
person  cannot  be  expected  to  know  whether  he  performs  his  duties  properly 
or  otherwise,  but  must  rely  upon  his  report  as  to  the  thoroughness  and 
accuracy  of  his  work.  .  .  .  The  City  is  entitled  to  recover  back  the 
amounts  paid,  upon  proving  that,  through  the  incompetence  or  the  negli- 
gence of  defendants,  the  report  was  in  substance  misleading  and  false.  .  .  . 
The  damages  claimed  on  account  of  the  losses  resulting  from  the  defalca- 
tions of  the  clerk  and  the  insolvency  of  his  surety  are  too  remote  to  be 
recovered,  without  showing  the  existence  of  special  circumstances,  known 
to  defendants,  from  which  they  ought  to  have  known  that  such  losses  were 
likely  to  result  from  a  failure  to  disclose  the  true  condition  of  affairs. 


^  East  Grand  Forks  v.  Steele,  121  Minn.  296;  45  L.  R.  A.  (N.  S.)  205;  141 
N.  W.  181 ;  Ann.  Cas.  1914  C,  720. 


12  AUDITING— GENERAL  PRINCIPLES 

In  another  case^  it  was  agreed  that  the  accountant  should 
frequently  check  a  corporation's  cash  account  and  verify  the 
items.  The  cash  and  agency  accounts  were  not  verified,  resulting 
in  the  failure  to  discover  losses  due  to  the  embezzlements  and 
defalcations  of  a  cashier. 

In  sustaining  a  counterclaim  for  damages  against  the  accoimt- 
ant  the  court  quoted  from  Cooley's  "The  Law  of  Torts, "^  as 
follows: 

Every  man  who  ofiFers  his  services  to  another  and  is  employed,  assumes 
the  duty  to  exercise  in  the  employment  such  skill  as  he  possesses  with 
reasonable  care  and  diligence.  In  all  those  employments  where  peculiar 
skill  is  requisite,  if  one  offers  his  services,  he  is  understood  as  holding 
himself  out  to  the  public  as  possessing  the  degree  of  skill  commonly  pos- 
sessed by  others  in  the  same  employment,  and  if  his  pretensions  are  un- 
founded, he  commits  a  species  of  fraud  upon  every  man  who  employs  him 
in  reliance  on  his  public  profession.  But  no  man,  whether  skilled  or 
unskilled,  undertakes  that  the  task  he  assumes  shall  be  performed  suc- 
cessfully, and  without  fault  or  error.  He  undertakes  for  good  faith  and 
integrity,  but  not  for  infallibility.  ... 

and  said,  ''Had  an  examination  and  checking  of  the  New  York 
office  cash  account,  performed  with  that  degree  of  skill  demanded 
by  the  rule  which  has  been  noticed,  resulted  in  preventing  de- 
fendant's loss,  in  whole  or  in  part,  the  plaintiff  (the  accountant) 
should  respond  in  damages." 

Professional  Ethics 

Serious  consideration  has  been  given  by  the  American  Insti- 
tute of  Accountants  to  the  advisability  of  adopting  definite  rules 
as  a  guide  to  the  practicing  accountant  and  as  notice  to  the  busi- 
ness world  that  the  professional  accountant,  Hke  the  lawyer  and 
doctor,  adheres  to  rules  of  professional  ethics.  With  this  end  in 
view,  the  Council  of  the  American  Institute  has  approved  the 
following  rules: 


3  Smith  V.  London  Assurance  Corporation,  109  App.  Div.  882;  96  N.  Y. 
Supp.  820. 

4  Second  edition,  page  277. 


THE  AUDITOR  AND  HIS  WORK  13 

Rules  of  American  Institute. — Rules  of  professional  con- 
duct, including  amendments  and  additions  prepared  by  the 
committee  on  professional  ethics  and  approved  by  the  council 
prior  to  September  30,  1920: 

(i)  A  firm  or  partnership,  all  the  individual  members  of  which  are 
members  of  the  institute  (or  in  part  members  and  in  part  associates,  pro- 
vided all  the  members  of  the  firm  are  either  members  or  associates) ,  may 
describe  itself  as  ''Members  of  the  American  Institute  of  Accountants"; 
but  a  firm  or  partnership,  all  the  individual  members  of  which  are  not 
members  of  the  institute  (or  in  part  members  and  in  part  associates),  or 
an  individual  practising  under  a  style  denoting  a  partnership  when  in  fact 
there  be  no  partner  or  partners,  or  a  corporation,  or  an  individual  or  in- 
dividuals practising  under  a  style  denoting  a  corporate  organization,  shall 
not  use  the  designation  "Members  (or  Associates)  of  the  American  In- 
stitute of  Accountants." 

(2)  The  preparation  and  certification  of  exhibits,  statements,  schedules 
or  other  forms  of  accountancy  work,  containing  an  essential  misstatement 
of  fact  or  omission  therefrom  of  such  a  fact  as  would  amount  to  an  essential 
misstatement,  or  a  failure  to  put  prospective  investors  on  notice  in  respect 
of  an  essential  or  material  fact  not  specifically  shown  in  the  balance  sheet 
itself,  shall  be,  ipso  facto,  cause  for  expulsion  or  for  such  other  discipline  as 
the  council  may  impose,  upon  proper  presentation  of  proof  that  such  mis- 
statement was  either  wilful  or  the  result  of  such  gross  negligence  as  to  be 
inexcusable. 

(3)  No  member  shall  allow  any  person  to  practise  in  his  name  as  a 
public  accountant  who  is  not  a  member  of  the  institute  or  in  partnership 
with  him  or  in  his  employ  on  a  salary. 

(4)  No  member  shall  directly  or  indirectly  allow  or  agree  to  allow  a 
commission,  brokerage  or  other  participation  by  the  laity  in  the  fees  or 
profits  of  his  professional  work;  nor  shall  he  accept  directly  or  indirectly 
from  the  laity  any  commission,  brokerage  or  other  participation  for  pro- 
fessional or  commercial  business  turned  over  to  others  as  an  incident  of  his 
services  to  clients. 

(5)  No  member  shall  engage  in  any  business  or  occupation  con- 
jointly with  that  of  a  public  accountant,  which  in  the  opinion  of  the 
executive  committee  or  of  the  council  is  incompatible  or  inconsistent 
therewith. 

(6)  No  member  shall  certify  to  any  accounts,  exhibits,  statements, 
schedules  or  other  forms  of  accountancy  work  which  have  not  been  verified 
entirely  under  the  supervision  of  himself,  a  member  of  his  firm,  one  of  his 


14  AUDITING— GENERAL  PRINCIPLES 

staff,  a  member  of  this  institute  or  a  member  of  a  similar  association  of 
good  standing  in  foreign  countries  which  has  been  approved  by  the  council. 

(7)  No  member  shall  take  part  in  any  effort  to  secure  the  enactment  or 
amendment  of  any  state  or  federal  law  or  of  any  regulation  of  any  govern- 
mental or  civic  body,  affecting  the  practice  of  the  profession,  without 
giving  immediate  notice  thereof  to  the  secretary  of  the  institute,  who  in 
turn  shall  at  once  advise  the  executive  committee  or  the  council. 

(8)  No  member  shall  directly  or  indirectly  solicit  the  clients  or  en- 
croach upon  the  business  of  another  member,  but  it  is  the  right  of  any 
member  to  give  proper  service  and  advice  to  those  asking  such  service  or 
advice. 

(9)  For  a  period  not  exceeding  two  years  after  notice  by  the  committee 
on  ethical  publicity  no  member  or  associate  shall  be  permitted  to  dis- 
tribute circulars  or  other  instruments  of  publicity  without  the  consent 
and  approval  of  said  committee. 

(10)  No  member  shall  directly  or  indirectly  offer  employment  to  an 
employee  of  a  fellow  member  without  first  informing  said  fellow  member  of 
his  intent.  This  rule  shall  not  be  construed  so  as  to  inhibit  negotiations 
with  anyone  who  of  his  own  initiative  or  in  response  to  public  advertise- 
ment shall  apply  to  a  member  for  employment. 

(11)  No  member  shall  render  professional  service,  the  anticipated  fee 
for  which  shall  be  contingent  upon  his  findings  and  results  thereof. 

The  student  of  accounting  and  the  young  practitioner  should 
familiarize  themselves  with  these  recommendations  and  keep  in- 
formed regarding  the  development  of  rules  of  ethics  of  the  pro- 
fession. 

Action  of  Institute  of  Chartered  Accountants. — In  the 
annual  address  delivered  April  5,  1916,  Sir  Woodburn  Kirby, 
President  of  the  Institute  of  Chartered  Accountants  in  England 
and  Wales,  said  that  charges  of  unprofessional  conduct  had  been 
made  and  investigated  with  the  result  that  in  four  cases  members 
were  suspended  from  membership  for  advertising;  in  one  case  a 
member  was  suspended  for  holding  himself  out  as  quahfied  to  act 
imder  a  certain  statute  when  he  was  not  so  qualified ;  in  one  case  a 
member  was  suspended  for  acts  of  default  in  his  statutory  duties 
under  an  Act  of  Parliament;  in  one  case  a  member  was  suspended 


THE  AUDITOR  AND  HIS  WORK  15 

for  falsely  certifying  to  the  conditions  of  service  of  an  articled 
clerk. 

Teistdency  in  United  States. — As  an  indication  of  the 
tendency  in  this  country  to  hold  the  accountant  strictly  respon- 
sible, the  following  extracts  from  an  editorial  in  the  Journal  of 
Accountancy,  January,  1918,^  are  worthy  of  consideration: 

The  accountant  who  acquiesces  in  any  attempt  at  evasion  of  taxes  is  a 
criminal  in  the  moral,  and,  if  detected,  in  the  legal  sense. 

Of  course,  it  is  the  duty  of  every  accountant  to  safeguard  the  true  in- 
terests of  his  cUent.  We  are  speaking  now  of  those  who  might  seek  to  serve 
interests  which  would  be  untrue  and  unworthy. 

Speaking  for  the  American  Institute  of  Accountants,  it  may  be  well 
to  impress  upon  members  and  associates  the  fact  that  the  organization 
stands  firmly  for  right,  and  if  any  attempt  on  the  part  of  a  member  or 
associate  to  evade  the  full  extent  of  taxation  measures  is  brought  to  the 
attention  of  the  institute,  discipline  will  certainly  follow  without  delay  or 
mercy. 

These  rules  may  appear  to  be  severe  but  in  many  cases  courts 
have  held  that  the  recognized  professional  standards  of  ethics  for 
lawyers  apply  even  in  the  absence  of  state  statutes.  The  legal 
code  of  ethics  does  not  permit  a  lawyer  to  advertise,  and  one  court 
has  decided  that  a  lawyer  who  sohcits  a  case  cannot  recover  for 
his  services.  ^ 

Report  of  One  State  Society. — A  committee  of  one  of  our 
state  societies  in  a  report  on  "Proposed  Rules  of  Ethical  Conduct" 
reported,  in  part,  as  follows: 

The  most  worthy  and  effective  advertisement  possible,  even  for  a 
young  accountant,  and  especially  with  his  brother  accountants,  is  the 
establishment  of  a  well  merited  reputation  for  professional  capacity  and 
fidelity.  This  reputation  cannot  be  forced,  but  must  be  the  outcome  of 
character  and  conduct.     The  publication  and  circulation  of  ordinary 


5  Volume  XXV,  pages  48  and  49. 

^  Ingersoll  et  al.  v.  Coal  Creek  Coal  Company  et  al.,  117  Tennessee  Reports, 
263. 


l6  AUDITING— GENERAL  PRINCIPLES 

simple  business  cards,  being  a  matter  of  personal  taste  or  local  custom,  and 
sometimes  of  convenience,  is  not  per  se  improper.  But  solicitation  of 
business  by  circulars,  or  advertisements,  or  by  personal  communications  or 
interviews,  not  warranted  by  personal  relations,  is  unprofessional.  The 
accountant  should  not  purchase  any  interest  in  the  subject  matter  or 
business  of  any  client.  The  magnitude  of  the  interests  inspected  by  certi- 
fied public  accountants,  the  importance  of  the  accountants'  positions,  and 
all  other  like  self-laudations  lower  the  tone  of  our  high  calling  and  are 
intolerable. 

In  the  foregoing  discussion  regarding  professional  ethics  it 
may  appear  that  undue  importance  has  been  attached  to  viola- 
tions of  those  rules  of  ethics  or  conduct  relating  to  advertising  or 
other  practices  affecting,  to  a  large  extent,  the  accountants'  in- 
terests only.  If  this  impression  is  received,  it  must  not  be  inferred 
that  it  represents  the  author's  point  of  view.  He  does  not  condone 
the  violations  of  those  rules  of  ethics  intended  to  discourage  ad- 
vertising or  other  forms  of  solicitation ;  but  he  realizes  that  they 
are,  in  the  last  analysis,  violations  of  good  taste  only,  while  the 
infractions  of  those  rules  covering  relations  with  the  chents  or 
with  the  public  are  the  really  serious  departures  from  correct 
professional  conduct. 

To  prevent  such  infractions,  he  would  emphasize  the  impor- 
tance of  developing  to  the  highest  degree  the  feeling  of  moral 
responsibility  on  the  part  of  accountants,  and  he  would  urge  an 
even  wider  conception  of  moral  responsibiHty  than  the  avoidance 
of  violations  and  the  penalties  which  attach  to  them.  Moral 
responsibility  is  all-inclusive :  it  covers  relations  with  the  clients — 
to  do  good  work;  relations  with  the  investor  or  lender — to  make 
every  statement  so  full  and  complete  that  it  cannot  be  misunder- 
stood; relations  with  the  business  community — to  devote  his 
ability  and  energy  to  the  improvement  of  business  practices; 
relations  with  the  fellow  members — to  deal  with  them  honorably 
and  unselfishly;  relations  with  the  staff — to  provide  opportunities 
for  their  self-improvement  and  advancement.  The  really  impor- 
tant work  of  the  accounting  societies  can  be  directed  toward  the 


THE  AUDITOR  AND  HIS  WORK  l^ 

growth  of  this  feehng  of  moral  responsibihty.  In  makmg  this 
statement  it  should  not  be  thought  that  the  author  is  charging 
the  societies  with  neghgence  in  this  respect — his  purpose  is  simply 
to  stress  the  importance  of  the  constructive  side  of  their  work  and 
its  possibilities,  as  compared  with  their  regulatory  activities. 


CHAPTER   II 

THE  PURPOSES  OF  AN  AUDIT 

The  average  business  man  is  not  as  familiar  with  the  purposes 
and  advantages  of  an  audit  as  he  should  be.  A  number  have 
retained  professional  auditors  and  have  gained  their  impressions 
of  what  an  audit  should  be  from  the  experiences  growing  out  of 
such  employment. 

A  Constructive  Program 

The  program  of  an  auditor  is  based  largely  on  accumulated 
experience  and  the  proper  application  to  a  given  subject  of  such 
part  of  the  experience  as  will  do  the  most  good.  Conversely, 
those  who  are  to  be  audited — officers  of  corporations,  business 
men  generally,  and  all  those  charged  with  the  management  or 
supervision  of  accounts  and  finance — profit  greatly  if  due  consid- 
eration is  given  to  the  mistakes  and  failures  of  others;  a  survey 
of  the  purposes  and  advantages  of  an  audit  will  suggest  to  them 
new  lines  of  thought,  possibilities  of  greater  efficiency  and  econ- 
omy, the  overwhelming  value  of  trustworthy  records  so  that 
remedial  measures  may  be  adopted  in  advance  rather  than  after 
the  visit  of  a  professional  auditor. 

The  Purposes  of  an  Audit 

The  successful  auditor  is  the  best  medium  through  which 
the  business  public  will  gain  knowledge  of  the  advantages  of  an 
audit.  To  be  successful  the  auditor  himself  must  have  a  thorough 
and  definite  grasp  of  the  purposes  of  an  audit. 

The  following  observations  and  suggestions  are  based  upon  a 
careful  study  of  actual  conditions  and  may  be  relied  upon  by  the 
student  as  representative  of  the  accumulated  experience  of  the 
auditors  who  head  the  profession  at  the  present  time. 

i8 


THE  PURPOSES  OF  AN  AUDIT  19 

The  Former  Point  of  View. — In  what  might  be  called  the 
formative  days  of  auditing,  students  were  taught  that  the  chief 
objects  of  an  audit  were : 

1 .  The  detection  or  prevention  of  fraud 

2.  The  detection  or  prevention  of  errors 

but  in  recent  years  there  has  been  a  decided  change  in  the  demand 
and  in  the  service.  Financiers  and  business  men  who  originally 
retained  professional  auditors  to  look  for  fraud  or  errors  have 
enlarged  their  demands  and  now  require  a  vastly  broader  and 
more  important  class  of  work,  which  those  auditors  who  have 
advanced  in  skill  and  knowledge  have  been  able  to  understand 
and  perform.  We  must  therefore  relegate  the  former  "chief 
objects"  to  a  subordinate  position  without  in  any  way  depreciat- 
ing their  importance. 

The  Present-Day  Point  of  View. — The  relative  positions 
of  the  present-day  purposes  are: 

1.  To  ascertain  the  actual  financial  condition  and  earnings 

of  an  enterprise  for: 

(a)  Its  proprietors  (partners  or  stockholders). 

(b)  Its  executives  (managers,  officers,  or  directors). 

(c)  Bankers  or  investors  who  are  considering  the  pur- 

chase of  its  securities. 

(d)  Bankers  who  are  considering  the  discounting  or 

purchasing  of  its  promissory  notes. 

2.  To  detect  fraud  or  errors,  as  explained  in  later  chap- 

ters of  this  book. 

Objects  to  be  Accomplished. — The  results  secured  by  audi- 
tors are  required  for  the  following,  among  other  purposes: 

I.  In  order  that  stock  and  bond  holders  or  other  owners  or 
creditors  may  have  submitted  to  them  at  regular  intervals  a 
comprehensive,  even  though   a   condensed,   statement  of   the 


20  AUDITING— GENERAL  PRINCIPLES 

financial  position  and  the  net  results  of  the  operations  of  the  busi- 
ness in  which  they  have  a  proprietary  interest,  and  that  the  fairness 
and  accuracy  in  all  essential  particulars  of  the  statement  sub- 
mitted may  be  attested  by  means  of  a  certificate  or  report  of  a 
disinterested  and  competent  authority. 

2.  Upon  a  proposed  sale  or  incorporation  or  other  change  in 
form  or  management,  such  as  an  attempt  to  bring  in  additional 
capital,  or  the  death  of  a  partner  or  large  stockholder.  Matters 
of  the  highest  importance  arise  in  connection  with  the  interests  of 
partners  in  the  event  of  death  or  other  change  in  the  partnership 
relations. 

3.  To  submit  similar  statements  in  more  detail  to  banks  and 
note-brokers  as  a  basis  of  credit. 

4.  To  submit  certified  statements  to  the  mercantile  agencies 
and  to  other  organizations  which  call  for  periodical  reports. 

5.  To  ascertain  the  true  causes  of  fluctuations  in  profits  or 
expenses. 

6.  To  state  the  facts  in  disputes  or  litigation,  and  to  investi- 
gate the  causes  of  bankruptcy  for  creditors  or  stockholders. 

7.  To  prepare  in  whole  or  in  part  reports  to  governmental 
bodies  or  departments  for  taxation  or  other  purposes. 

8.  To  guard  against  losses  due  to  inadequate  records  and  poor 
methods,  lack  of  internal  check  or  carelessness. 

9.  To  protect  the  public  through  the  examinations  of  govern- 
mental departments,  pubHc  utiKties,  and  private  corporations 
when  accurate  information  is  required  for  voluntary  or  involun- 
tary price-fixing. 

This  is  a  partial  hst  only  of  the  manifold  purposes  for  which 
audits  or  investigations  are  being  demanded.  The  nineteenth 
century  auditor  who  looked  chiefly  for  fraud  or  errors  served  a 
useful  purpose,  but  his  methods  now  illustrate  the  history  rather 
than  the  modern  practice  of  auditing. 

Due  consideration  will  now  be  given  the  subject  of  fraud 
and  errors.    In  subsequent  chapters  the  present-day  demands  for 


THE  PURPOSES  OF  AN  AUDIT  21 

"higher"  auditing  will  be  met  with  a  full  discussion  of  the  more 
important  work  of  the  professional  auditor. 

The  Minor  Objects  of  an  Audit 

The  elementary  or  minor  objects  of  an  audit  are: 

1.  The  detection  of  fraud. 

2.  The  detection  of  errors,  and  conversely  the  prevention  of 

fraud  and  the  prevention  of  errors,  particularly  of 
errors  of  principle. 

In  addition  there  is  the  moral  effect  of  an  audit,  tending  to 
keep  the  work  of  the  office  staff  sharply  up  to  date.  This  might 
be  classed  as  a  constructive  object. 

I.  The  Detection  of  Fraud. — There  can  be  no  doubt  but 
that  the  business  public  look  upon  the  discovery  of  fraud  as  an 
important  object  to  be  attained  by  an  audit,  and  experience  has 
demonstrated  that  sufficient  fraud  has  been  so  disclosed  to  war- 
rant a  continuance  of  the  service  of  auditors  who  are  retained  to 
discover  fraud  if  it  exists. 

Gradually,  however,  the  business  man  is  being  educated  to 
understand  that  the  discovery  of  fraud  is  but  one  of  the  objects 
of  an  audit,  and  by  no  means  the  most  valuable  to  him. 

The  detection  of  fraud  is  first  in  the  logical  presentation  of 
the  objects  of  an  audit,  because  less  experience  is  required  to  un- 
earth it,  and  more  definite  suggestions  can  be  made  to  the  student 
in  regard  to  it  than  is  true  of  the  more  important  branches  of  the 
auditor's  duties. 

While  an  auditor  who  brings  to  bear  all  of  his  skill  and  re- 
sources, and  who  leaves  no  stone  unturned  in  his  search  for  fraud, 
but  fails  to  discover  a  well-concealed  defalcation,  is  legally  ex- 
empt from  HabiHty  therefor,  yet  he  is,  and  properly  should  be, 
considered  professionally  responsible  for  such  failure,  and  his 
practice  suffers  accordingly.  Therefore  particular  attention  must 
be  paid  to  all  possible  avenues  which  are  open  to  the  dishonest 


22  AUDITING— GENERAL  PRINCIPLES 

clerk  or  official  who  has  an  opportunity  to  manipulate  the  records 
of  business  transactions. 

Opportunities  for  wrong-doing  vary,  as  a  rule,  with  the  size 
of  the  undertaking.  In  a  small  business  the  details  are  apt  to  be 
supervised  by  one  or  all  of  the  proprietors,  while  in  a  large  busi- 
ness much  of  the  detail  is  necessarily  left  to  subordinates.  The 
auditor  must  be  governed  by  the  circumstances  surroimding  each 
engagement  and  then  determine  the  amount  of  detail  to  be 
covered. 

(a)  Misappropriation  of  Money  or  Goods.  Usually  fraud  con- 
sists of  defalcations  involving  the  misappropriation  of  cash, 
either  by  the  failure  to  account  for  cash  receipts  or  by  the  entry  of 
payments  which  are  fictitious  in  part  or  in  whole. 

In  the  following  pages  is  outHned  a  procedure  based  on  long 
experience  which  will  disclose  such  practices  in  all  ordinary 
cases. 

With  respect  to  the  misappropriation  of  assets  other  than  cash, 
a  far  more  difficult  task  is  at  hand,  but  experience  in  such  cases 
has  also  permitted  the  outlining  of  general  rules  which  will  mater- 
ially assist  the  auditor. 

(b)  Manipulation  of  Accounts  for  Other  Purposes.  The  ab- 
straction of  cash  or  of  goods  is  not  the  only  reason  for  the  manipu- 
lation of  accounts.  The  auditor  who  has  fully  covered  these  two 
classes  of  frauds  must,  in  addition,  consider  the  possibihty  of 
other  irregularities. 

In  many  imdertakings  the  sources  of  cash  receipts  and  the 
disposition  of  cash  expenditures  are  so  carefully  guarded  that  a 
misappropriation  of  cash  is  almost  impossible. 

It  is  hard  to  convince  the  business  man  whose  accounts  are  so 
guarded,  that  an  audit  is  of  value;  but,  relying  again  on  exper- 
ience, it  has  been  demonstrated  time  and  again  that  pecuniary 
profit  in  such  cases  may  be  obtained  by  the  manipulation  of 
records.  Usually  the  fraud  has  been  perpetrated  by  an  official 
(frequently  one  who  has  the  entire  confidence  of  everyone)  who 
has  an  interest  in,  or  who  receives  a  bonus  based  on,  the  net 


THE  PURPOSES  OF  AN  AUDIT  23 

profits  of  a  business  or  of  a  department  thereof.  In  other  cases 
the  purpose  is  to  deceive  bankers,  creditors,  or  stockholders. 

The  auditor  must  have  all  these  purposes  constantly  in  mind 
when  determining  his  course  of  action.  If  he  does  not  consider 
all  the  elements  involved  before  commencing  a  given  engagement, 
he  may  find  at  the  end  of  a  detailed  audit  that  a  balance  sheet 
audit  would  have  enabled  him  to  secure  satisfactory  results  in 
much  less  time. 

In  discussing  hereafter  the  respective  advantages  of  these 
^wo  classes  of  audits,  the  author  will  endeavor  to  assist  the  prac- 
titioner in  the  selection  of  a  proper  line  of  procedure. 

2.  The  Detection  of  Errors. — When  professional  auditing 
was  in  a  formative  state  in  this  country,  auditors  were  frequently 
engaged  to  adjust  accounts  which  had  been  kept  badly  by  ineffi- 
cient clerks.  It  was  found  that  the  books  were  not  in  balance, 
and  that  in  order  to  adjust  them  a  vast  number  of  errors  had  to 
be  located  and  corrected.  In  many  cases  this  work  consumed 
months,  and  a  correspondingly  large  fee  was  asked.  This  was 
called  *' auditing,"  but  in  reality  it  was  accounting  work  of  the 
most  elementary  kind.  A  careful  bookkeeper  unacquainted  with 
most  of  the  principles  of  accountancy  could  have  performed  the 
service  equally  well  and  far  more  cheaply. 

This  practice  cast  more  or  less  discredit  on  professional 
auditors,  so  that  the  tendency  during  recent  years  has  been  to 
belittle  the  importance  of  locating  errors  in  books  of  accounts 
and  to  magnify  the  advantages  of  concentrating  on  the  search  for 
fraud  and  the  verification  of  the  balance  sheet. 

The  author  feels  that  this  branch  of  auditing  should  be 
accorded  its  proper  place  in  stating  the  objects  of  an  audit,  and 
the  attention  of  the  student  is  particularly  called  to  the  points  of 
importance  in  the  detection  of  errors. 

(a)  Errors  of  Principle.  This  is  the  most  important  class  of 
errors  and  is  one  which  the  auditor  must  never  overlook. 

Errors  of  principle  usually  affect  both  the  income  account 


24  AUDITING— GENERAL  PRINCIPLES 

and  the  balance  sheet.  The  most  common  error  is  to  debit  an 
asset  instead  of  an  expense  account.  For  instance,  an  item  of 
repairs  will  be  charged  to  buildings  account,  or  a  payment  cover- 
ing expenses  or  services  will  be  charged  to  the  personal  account  of 
the  payee  and  thus  be  included  among  the  accounts  receivable, 
instead  of  being  charged  to  an  expense  account. 

Other  errors  of  principle  do  not  affect  the  net  income,  but 
may  seriously  affect  the  conclusions  which  are  drawn  from  the 
various  revenue  or  expense  accounts.  For  instance,  an  execu- 
tive may  have  determined  that  the  advertising  appropriation 
shall  be  Hmited  to  5  per  cent  of  the  sales.  A  large  item  of  adver- 
tising expense  may  be  charged  to  some  other  expense  account  in 
error,  with  the  result  that  the  executive,  depending  upon  the 
ledger  to  give  him  the  total  expenditure,  will  authorize  additional 
advertising  and  thus  incur  an  unintentional  and  perhaps  unneces- 
sary expense. 

Errors  of  principle  are  most  easily  detected  by  making  an 
intelligent  analysis  of  the  accounts  in  connection  with  the  pre- 
paration of  the  income  account  and  the  balance  sheet. 

(b)  Clerical  Errors.  These  are  the  most  frequent  errors 
which  exist,  and^  unfortunately,  few  books  of  accounts  are  free 
from  them.  They  consist  of  errors  in  the  footings  and  forwardings 
of  the  books  of  original  entry  and  ledgers;  errors  in  postings  other 
than  those  mentioned  under  (a),  consisting  of  postings  to  wrong 
accounts  in  the  same  class,  as  to  one  customer  or  creditor  instead 
of  another,  or  the  posting  of  an  incorrect  amount,  posting  to  the 
wrong  side  of  the  ledger,  or  errors  in  drawing  off  the  trial  balance. 

These  errors  are  usually  due  to  carelessness,  but  the  auditor 
is  not  justified  in  assuming  that  accounts  in  which  such  errors 
exist  are  free  from  fraud.  He  must  differentiate  between  clerical 
errors  and  intentional  manipulation  of  the  records.  A  careful 
examination  must  therefore  be  made  of  enough  of  these  errors  to 
enable  the  auditor  to  satisfy  himself  that  they  are  bona  fide. 
For  instance,  an  excessive  footing  of  a  pay-roll  or  expense  account 
might  be  due  to  either  carelessness  or  fraud;  the  posting  of  a 


THE  PURPOSES  OF  AN  AUDIT  25 

greater  amount  to  the  credit  of  a  customer's  account  than  is 
shown  in  the  cash  book  might  be  an  honest  error  in  posting  or  it 
might  indicate  an  attempt  to  conceal  a  defalcation. 

A  fair  test  of  these  errors,  however,  is  sufficient.  It  is  no  part 
of  an  auditor's  duty  (as  such)  to  locate  all  clerical  errors,  and  the 
auditor  who  devotes  too  large  a  part  of  his  time  to  this  work  lays 
himself  open  to  just  criticism. 

Auditors  lose  sight  of  the  fact  that  the  closing  of  books  and 
the  resulting  balance  sheets  are  based  on  estimates  only.  Some 
auditors  spend  many  hours  in  adjusting  balance  sheet  items  in 
order  to  correct  a  few  trifling  errors,  when  there  are  valuations  of 
hundreds  of  thousands  of  dollars  in  plant,  merchandise  stocks, 
etc.,  all  of  which  are  necessarily  estimates  and  which  fluctuate 
from  day  to  day — as  must  the  value  of  all  materials  and  goods. 
So  long,  therefore,  as  small  errors  in  calculations,  extensions,  etc., 
do  not,  relatively  speaking,  actually  affect  the  balance  sheet, 
time  should  not  be  wasted  on  such  adjustments. 

(c)  Errors  of  Omission.  An  auditor  is  justified  in  spending 
more  time  in  looking  for  errors  of  omission  than  in  connection 
with  any  other  class  of  errors.  Where  the  internal  check  (see 
page  ()2  et  seq)  is  not  perfect,  the  utmost  care  must  be  taken  to 
verify  all  possible  sources  of  revenue,  to  ascertain  whether  or  not 
all  such  items  are  entered  in  the  books.  Errors  of  omission  usually 
do  not  affect  the  trial  balance  and  are  therefore  not  detected 
automatically.  They  are  to  be  distinguished  from  the  class  of 
errors  where  items  are  not  posted  at  all,  because  these  (except 
where  both  sides  of  a  journal  entry  are  not  posted)  affect  the  trial 
balance,  and  the  usual  checking  back  of  the  postings  would  locate 
the  differences. 

Instances  of  errors  of  omission  are:  goods  may  be  delivered, 
but  not  billed;  rent  due  may  not  be  charged  or  collected.  On  the 
other  hand,  purchases  may  be  made  and  the  goods  received,  but 
the  invoices  for  same  may  not  be  entered  in  the  books.  In  order 
to  cover  this  class  of  errors  the  auditor  should  locate  all  books  of 
original  entry,  whether  they  are  so-called  memorandum  books  or 


26  AUDITING— GENERAL  PRINCIPLES 

other  informal  records,  and  a  fair  selection  of  items  then  should  be 
traced  into  the  regular  books  of  account.  If  the  test  does  not  dis- 
close any  material  differences,  it  may  be  assumed  that  the  records 
are  accurate.  If  the  test  should  disclose  one  or  more  errors  of 
sufficient  size  to  affect  the  results  favorably  or  unfavorably,  a 
more  extensive  test  should  be  made.  It  might  be  well,  however, 
before  extending  the  verification,  to  request  authority  for  so 
doing  from  the  cHent. 

In  an  examination  of  the  accounts  of  a  publisher  the  author 
compared  the  advertisements  appearing  in  one  issue  of  a  popular 
magazine  with  the  book  in  which  charges  to  advertisers  were 
entered.  It  was  found  that  an  insertion  of  a  full  page  had  not 
been  charged  for.  The  item  was  billed  and  collected.  Thereupon 
the  other  eleven  issues  were  carefully  checked,  but  no  other  omis- 
sion was  found. 

If  the  auditor  names  a  fixed  fee  for  an  audit,  it  is  always  well 
to  state  that  tests  only  will  be  made.  If  an  error  is  discovered  in 
the  test,  the  auditor  has  fulfilled  his  agreement  and  need  not  go 
further  unless  an  additional  fee  is  arranged  for.  If  he  will  broach 
the  subject  as  soon  as  the  test  is  completed,  there  will  probably 
be  no  difficulty  in  securing  an  extra  allowance,  but  if  no  reference 
is  made  to  his  purpose  to  charge  extra  for  additional  work,  he  will 
usually  have  difficulty  in  collecting  anything  at  all  additional, 
no  matter  how  many  or  how  few  errors  are  brought  to  Hght. 

(d)  Errors  of  Commission.  These  occur  chiefly  in  books  and 
records  of  original  entry,  and  consist  of  items  which  are  incor- 
rectly recorded,  either  in  whole  or  in  part. 

For  instance,  an  entry  in  the  sales  book  may  be  incorrect  as 
to  quantities,  or  in  the  extension  of  the  items.  These  errors  do 
not  affect  the  trial  balance  and  frequently  remain  undetected. 

The  same  tests  as  are  recommended  above,  under  (c),  should 
be  followed,  except  that  it  is  not  usually  necessary  to  cover  as 
many  items.  Calculations  of  purchase  and  sales  items  are  fre- 
quently verified  by  two  persons  in  the  offices  where  they  origi- 
nate, and  almost  invariably  are  checked  in  the  offices  to  which  they 


THE  PURPOSES  OF  AN  AUDIT  27 

are  sent.  The  test,  therefore,  may  be  extremely  limited,  provided 
it  is  apparent  that  care  is  taken  by  the  clerks  in  charge  of  such 
work. 

(e)  Of  setting  Errors.  These  occur  fairly  often,  and  while 
they  could  be  classed  under  the  other  headings  mentioned,  they 
are  dangerous  enough  to  deserve  special  mention. 

An  offsetting  error  is  one  which  is  counterbalanced  by  another 
error  or  errors.  It  is  an  annoying  type.  As  one  error  may  occur 
in  an  asset  or  liability  account  and  the  other  in  an  expense  or 
income  account,  an  auditor  is  not  justified  in  passing  any  accounts 
until  satisfied  that  such  errors  do  not  exist.  Of  course,  this  does 
not  mean  the  verification  of  every  posting,  but  it  does  call  for  the 
tests  or  analyses  described  more  fully  hereafter. 

Few  executives  realize  how  great  is  the  number  of  clerical 
errors  which  are  made  every  day.  Perhaps  these  are  most  numer- 
ous in  banks,  brokers'  offices,  and  other  offices  where  the  accounts 
are  balanced  daily.  An  immense  amount  of  work  is  accompHshed 
in  a  short  space  of  time.  Clerks  work  at  high  pressure,  and, 
knowing  that  there  will  be  a  check  on  their  work  before  they  leave 
at  night,  they  do  not  verify  their  entries  as  they  go.  This  is  the 
case  with  many  clerks  who  depend  on  the  monthly  trial  balance 
to  detect  their  errors.  Consequently  a  great  number  of  errors  are 
made,  but  as  soon  as  it  is  found  that  the  day's  work  must  be 
checked  back,  they  are  located  and  corrected.  Many  of  these 
errors  are  of  $10,  $100,  or  $1,000.  It  is  not  strange,  therefore,  if 
two  errors  of  the  same  amount  are  made  on  the  same  day  in 
different  departments,  so  that  the  accounts  for  that  day  actually 
balance  in  spite  of  the  two  errors. 

The  author  was  once  called  upon  by  the  senior  partner  of  a 
large  stock  exchange  house  who  was  greatly  troubled  by  the  fact 
that  two  errors  of  $100  each  had  been  made  on  a  certain  day  and 
had  remained  undetected  for  three  weeks.  He  felt  that  something 
was  wrong  with  the  system  of  accounts  or  with  his  clerks;  he  could 
not  decide  which.  He  was  advised  that  the  discovery  and  report- 
ing of  the  mistake  by  the  only  clerk  who  could  have  benefited 


28  AUDITING— GENERAL  PRINCIPLES 

by  it  indicated  that  fraud  was  not  intended,  but  that  if  a  similar 
case  arose  soon  again,  a  fuller  investigation  should  be  made. 

The  rule,  therefore,  is  that  an  offsetting  error  may  occur  at 
any  time,  but  that  the  law  of  averages  operates  against  much 
duplication. 


CHAPTER  III 

ADVANTAGES  OF    AN  AUDIT 

An  auditor's  duty  is  to  discover  and  disclose  the  truth  about 
accounts,  but  this  is  too  general  a  designation  of  his  duties  to 
use  when  confronted  with  a  specific  case.  Furthermore,  the 
business  world  must,  for  many  years  to  come,  be  educated  to  a 
proper  appreciation  of  an  accountant's  fimctions;  therefore  the 
present-day  auditor  must  be  a  teacher  as  well  as  an  adviser.  He 
miist  be  prepared  to  explain  the  purpose  of  his  work  and  set  forth 
clearly  the  objects  to  be  attained  as  the  result  of  his  labors. 

Verification  of  Balance  Sheet 

The  professional  auditor  must  give  the  impression  of  having 
a  scope  and  purpose  far  in  advance  of  the  old-time  auditor,  whose 
work  was  chiefly  confined  to  ascertaining  whether  the  accounting 
party  had  properly  recorded  all  receipts  and  payments  on  behalf 
of  his  principal.  In  fact,  the  old-fashioned  audit  was  a  cash 
audit.  A  modern  audit,  however,  although  it  includes  the 
examination  of  cash  transactions,  has  as  its  ultimate  purpose  the 
verification  of  the  balance  sheet. 

An  auditor  should  be  prepared  to  state  that  he  must  make 
such  an  examination  of  the  books  and  records  of  the  undertaking 
as  will  enable  him  to  satisfy  himself  as  to  whether  the  balance 
sheet  is  properly  drawn  up  to  exhibit  a  true  and  correct  state- 
ment of  its  financial  affairs. 

Promptness  Essential. — The  auditor  should  endeavor  to 
complete  his  examination  and  present  his  report  within  the  short- 
est possible  time  after  the  client's  accounts  have  been  closed,  in 
order  that  his  report  may  be  a  current  event,  and  therefore  of 

29 


30  AUDITING— GENERAL  PRINCIPLES 

immediate  and  vital  interest  rather  than  a  matter  of  history  too 
ancient  to  be  of  any  practical  use.  If  the  delay  is  due  to  the 
auditor's  neglect  or  inexperience,  obviously  he  is  not  to  be 
excused. 

In  any  event,  we  must  realize  that  the  principal  purpose  of 
financial  statements  is  to  ascertain  the  condition  of  the  enterprise 
and  to  determine  policies  to  maintain  or  increase  the  profits. 
If  the  reports  are  completed  a  long  time  after  the  close  of  the 
period,  say,  two  or  three  months,  it  is  quite  possible  that  some 
expenses  or  losses  may  have  been  incurred  which  could  have  been 
eliminated.  It  is  common  knowledge  that  some  large  enter- 
prises have  so  arranged  their  work  that  the  results  are  known 
in  a  few  days  after  the  close  of  the  fiscal  period.  There  is  no 
reason  why  many  other  concerns  cannot  do  hkewise.  In  such 
cases  the  auditor  can  complete  his  work  in  time  to  be  of  real 
value. 

Major  Advantages 

The  chief  advantages  of  an  audit  are,  of  course,  identical 
with  its  main  purposes.  The  minor  objects,  viz.,  that  fraud  will 
be  disclosed  if  it  exists;  that  technical  errors,  if  any,  will  be  dis- 
covered and  corrected;  that  errors  of  principle  if  they  exist,  will 
be  detected,  and  the  means  of  preventing  their  repetition  in  the 
future  pointed  out,  have  been  discussed. 

The  major  advantages  which  have  been  mentioned  will  now 
be  enlarged  upon. 

I.  Condition  of  Affairs. — An  accurate  balance  sheet, 
together]  with  an  income  statement,  reflecting  the  changes  in 
the  company's  financial  position,  are  prepared  by  a  disin- 
terested expert.  In  a  great  number  of  cases  these  statements 
made  by  the  auditor  are  the  first  accurate  information  which 
the  client  has  had  as  to  his  condition.  It  will  never  be  known 
how  many  enterprises  have  been  saved  from  ultimate  failure 
through  the  presentation  of  unwelcome  facts  by  an  auditor  who 


ADVANTAGES  OF  AN  AUDIT  3^ 

cannot  and  will  not  be  influenced  by  former  inaccurate  statements 
of  condition. 

The  tendency  to  fool  one's  self  has  been  so  strong  and  so 
general  that  the  ordinary  balance  sheet  in  the  pre-war  period, 
when  subjected  to  investigation  by  a  disinterested  third  person, 
required  drastic  treatment.  Except  in  the  comparatively  few 
cases  where  special  reason  existed  for  understating  values  or 
understating  profits,  most  business  men  were  unwilling  to  provide 
sufficient  depreciation,  they  were  unwilling  to  cut  down  inven- 
tory values,  and  they  were  reluctant  to  provide  sufficient  reserves 
against  accounts  receivable.  They  insisted  on  carrying  "souve- 
nirs" as  perfectly  good  assets,  and  they  borrowed  large  sums  of 
money  on  the  strength  of  such  souvenirs.  This  tendency  was  so 
general  that  most  bankers  in  scrutinizing  balance  sheets  mentally 
calculated  additional  reserves  against  the  assets  mentioned.  The 
result  was  that  the  conservative  business  man  who  had  provided 
sufficient  reserves  suffered  the  penalty  of  having,  in  effect,  his 
actual  current  assets  reduced  because  the  non-conservative  man 
had  neglected  to  provide  sufficient  reserves. 

As  almost  every  item  of  a  balance  sheet  affects  directly  or 
indirectly  the  computation  of  taxes,  it  is  obvious  that  the  great- 
est single  factor  which  has  ever  influenced  balance  sheets  was  the 
federal  excess  profits  tax,  which  became  effective  as  of  January 
I,  1917. 

Generally  speaking,  balance  sheets  are  accurate  when  tax 
rates  are  high  and  profits  are  substantial.  It  cannot  be  said 
that  the  average  balance  sheet  is  accurate  when  tax  rates  are  low 
or  when  tax  rates  are  high  and  profits  are  not  substantial.  This 
refers  to  the  balance  sheet  as  it  is  made  up  without  supervision  or 
certification  from  an  outside  source. 

American  men  as  a  rule  are  optimists.  Furthermore,  it  is 
entirely  in  keeping  with  human  nature  if  a  proprietor  or  manag- 
ing officer  sets  forth  the  most  favorable  aspect  of  the  concern 
which  he  owns  or  manages.  Therefore,  accountants  in  the  past 
have  been  confronted  with  balance  sheets  which  the  proprietors 


32  AUDITING— GENERAL  PRINCIPLES 

honestly  believed  could  be  fully  substantiated  as  to  values,  and 
it  was  difficult  for  the  impartial  investigator,  who  took  a  different 
view  of  some  of  the  items,  to  convince  the  client  that  he,  the 
auditor,  was  right,  and  that  the  client  had  not  been  sufficiently 
conservative.  While  it  may  be  human  nature  to  present  the  best 
aspect  of  affairs,  it  is  also  human  nature  to  take  advantage  of 
circumstances  which  tend  to  increase  profits  or  save  expenses. 
As  has  been  remarked  heretofore,  the  levying  of  very  high  taxes, 
the  amount  of  which  was  influenced  very  greatly  by  a  conserv- 
ative, but  proper  attitude  as  respects  the  accounting  application 
of  business  items,  has  been  a  factor  of  very  great  weight  in  bring- 
ing down  balance  sheets  and  income  accounts  to  a  safe  and 
conservative  basis.  High  taxes  have  simply  encouraged  the 
attitude  of  conservatism  which  should  always  have  obtained 
because  the  successful  business  man  is  a  man  who  does  not  fool 
himself  and  such  a  man  would  very  naturally  be  in  favor  of  very 
liberal  depreciation,  would  scale  down  the  inventories  where 
necessary  to  do  so,  would  charge  an  expenditure  to  operating 
expense  rather  than  to  fixed  assets  if  there  were  any  option, 
would  look  with  doubt  upon  the  capitalization  of  intangible 
items  or  the  deferring  of  expenses  to  future  periods,  and  gener- 
ally, would  be  correct  but  conservative  in  all  accounting  matters. 

While  self-interest  during  the  period  of  high  taxes  tends  to 
encourage  the  preparation  of  statements  on  a  very  conservative 
basis,  should  not  the  bankers  in  future  years,  if  they  want  to 
avoid  bad  loans,  insist  that  balance  sheets  be  prepared  in  the 
same  manner  even  though  reduction  in  taxes  payable  may  no 
longer  be  the  actuating  motive? 

Every  bank  which  loans  money  should  classify  the  balance 
sheets  of  its  borrowers  and  not  consider  that  each  one  should  be 
expected  to  tell  its  own  story.  Management  is  just  as  important 
as  capital  and  a  balance  sheet  can  and  should  reflect  management. 
The  war  balance  sheet  may  show  large  net  worth  but  it  does  not 
necessarily  reflect  good  management,  because  large  profits  were 
made  by  the  majority  of  the  concerns.    Anyone  could  make 


ADVANTAGES  OF  AN  AUDIT  33 

money  in  most  industries  during  war  times  because  demand 
exceeded  supply. 

2.  Bank  Loans. — Certified  accounts  are  particularly  valuable 
as  a  basis  for  bank  loans.  All  leading  bank  managers  recognize 
the  assistance  rendered  to  them  in  the  course  of  their  business  by 
public  accountants.  The  officers  of  the  federal  reserve  banks 
have  gone  on  record  as  favoring  borrowers  whose  balance  sheets 
are  certified  to  by  ''outside"  accountants.  Even  if  a  business 
man  is  in  the  happy  position  of  not  requiring  occasional  aid  from 
his  banker,  his  financial  rating  is  considerably  higher  if  he  is 
thoroughly  up-to-date  in  the  care  of  his  books  and  accounts. 

The  extension  of  credit  by  a  bank  depends  on  the  judgment 
of  its  officers  as  to  the  ability  of  the  borrower  to  repay  the  loan 
when  due.  The  auditor,  by  reason  of  his  independence,  is  able  to 
assist  the  banker  in  forming  his  judgment.  The  prospective 
borrower  cannot  view  the  condition  of  his  own  business  without 
bias.  Borrowers  usually  do  not  anticipate  difficulty  in  securing 
extensions  of  time,  or  anticipate  future  conditions  to  be  more 
satisfactory  than  is  the  case  at  the  time  of  the  application.  The 
auditor  must,  in  a  measure,  pass  on  the  probability  and  the 
possibihty  of  the  future  in  the  light  of  past  results. 

This  does  not  excuse  an  auditor  who  estimates  a  definite  profit 
for  the  future,  out  of  which  a  bank  loan  will  be  paid,  but  it  does 
support  the  recent  statements  of  prominent  bankers  that  the 
services  of  professional  accountants  are  becoming  of  increasing 
value  to  them,  largely  because  they  are  able  to  report  orally  the 
result  of  their  "sizing  up"  of  the  borrower  or  the  prospective 
borrower. 

If  an  auditor  refrains  from  expressing  any  oral  opinion  on  the 
probabilities  of  the  future  of  a  business,  the  accounts  of  which  he 
has  just  subjected  to  the  most  thorough  analysis  and  scrutiny, 
it  is  possibly  because  he  relies  upon  the  ancient  fiction  that  an 
accountant  deals  with  facts  only,  and  that  future  results  are  not 
facts;  or  perhaps  he  is  afraid  to  express  his  own  convictions. 

VOL.  I — 3 


34  AUDITING— GENERAL  PRINCIPLES 

When  an  experienced  auditor  arrives  at  conclusions  based  on 
facts,  it  would  seem  only  fair  that  his  conclusions  should  be 
communicated  to  his  client  at  the  time  they  are  formed. 

It  is  an  unquestioned  advantage  for  any  borrower  to  be  able 
to  comply  with  the  requirements  of  the  banker  or  note-broker  to 
whom  he  applies  for  a  line  of  credit.  The  attention  of  a  pros- 
pective client  may  therefore  be  properly  drawn  to  the  official 
action  of  the  supreme  body  of  American  bankers. 

At  the  convention  of  the  American  Bankers'  Association, 
held  at  Denver,  Colo.,  in  1908,  the  Committee  on  Credit  Inform- 
ation reported,  urging  *'  that  every  member  exert  his  influence  to 
have  all  paper  purchased  from  note-brokers  presented  with 
accompanying  statements  audited  by  Certified  Public  Account- 
ants. .  .  .,"  and  to  that  end  asked  that  the  association,  by  the 
adoption  of  the  committee's  report,  "recommend  that  its 
members,  in  purchasing  commercial  paper  from  note-brokers, 
give  preference  to  such  names  as  furnish  accompanying  state- 
ments audited  by  Certified  PubHc  Accountants." 

Prominent  bankers,  from  time  to  time,  have  urged  their 
associates  in  conventions  and  elsewhere  to  require  all  prospective 
borrowers  to  furnish  certified  statements. 

Unfortunately,  competition  in  banking  circles  is  still  too  keen 
to  permit  this  rule  to  be  adopted.  Some  recent  large  losses  by 
banks,  arising  out  of  gross  overvaluations  of  assets  and  under- 
statements of  Habihties  on  the  part  of  borrowers,  may  incHne 
them  to  require  statements  certified  by  impartial  accountants. 

3.  Partnerships. — Partnership  books  should  always  be 
adjusted  by  a  professional  accountant,  if  for  no  other  reason 
than  that  he  will  act  impartially  and  comply  fully  with  the 
articles  of  copartnership.  These  accoimts  are  peculiarly  liable  to 
disturbances  by  causes  from  which  corporations  on  the  whole  are 
exempt.  Disputes  occur  as  to  salaries,  division  of  profits,  part- 
ners' overdrawings,  inattention  to  business,  and  many  other 
things  which  would  to  a  large  extent  be  obviated  if  the  books 


ADVANTAGES  OF  AN  AUDIT  35 

were  regularly  audited  by  a  competent  outsider.  A  partner  dies 
and  there  is  trouble  with  his  administrator  as  to  the  division  and 
withdrawal  of  the  decedent's  capital,  in  many  cases  resulting  in 
expensive  lawsuits  and  the  permanent  crippling  of  the  business. 
A  partnership  goes  into  bankruptcy,  perhaps  through  misconduct 
of  a  trusted  partner.  Had  a  continuous  audit  been  in  force  the 
fraud  might  have  been  nipped  in  the  bud.  Again,  for  the  pro- 
tection of  a  limited  or  special  partner,  or  of  a  silent  or  dormant 
partner,  a  periodical  independent  audit  is  essential. 

4.  Fire  Loss. — In  case  of  loss  of  merchandise  by  fire,  a 
properly  authenticated  balance  sheet  prepared  by  a  public 
accountant  is  a  material  aid  in  the  adjustment  of  claims.  This 
is  not  a  theory;  it  has  been  demonstrated  in  practice.  All 
business  men  anticipate  the  possibility  of  a  fire,  but  few  of  them 
consider  just  how  they  will  collect  their  insurance. 

During  the  progress  of  an  audit  the  auditor  should  ascer- 
tain the  methods  of  bookkeeping  in  force,  and  whether,  in  case 
of  fire,  the  records  would  be  properly  protected.  He  should 
ascertain  whether  a  perpetual  inventory  is  maintained  or  whether 
it  will  be  necessary  to  calculate  the  amount  of  the  loss  upon  the 
usual  basis,  that  is,  to  take  the  last  recorded  inventory,  add  pur- 
chases to  date  of  fire,  and  deduct  cost  of  goods  sold,  the  result 
being  the  stock  on  hand  at  time  of  fire. 

The  cost  of  goods  sold  is  most  often  ascertained  by  deducting 
from  the  sales  the  average  gross  profit  realized  in  prior  periods. 
Fire  insurance  adjusters  are  shrewd  and  experienced,  and  the 
business  man  whose  records  are  in  poor  order  is  usually  forced  to 
settle  upon  a  basis  satisfactory  to  the  adjuster.  If  the  business 
man's  accounts  are  in  good  shape  and  if  he  can  show  that  the  last 
inventory  has  been  certified  to,  he  can  decline  to  compromise  and 
can  insist  on  the  full  amount  of  his  claim  being  allowed. 

5.  Bonding. — A  cashier  whose  books  are  audited  regularly 
has  little  trouble  in  securing  a  good  company  to  act  as  surety  for 


36  AUDITING— GENERAL  PRINCIPLES 

him;  in  fact,  several  of  the  best  companies  insist,  as  part  of  the 
contract,  that  this  be  done  periodically. 

6.  Protection  of  Stockholders  and  the  Public. — The 
interests  of  the  real  proprietors  of  a  business  (the  stockholders 
in  the  case  of  a  corporation)  should  be  protected  in  every  feasible 
and  reasonable  manner.'  One  way  in  which  such  an  end  might 
be  served  would  be  to  conform  to  the  Enghsh  method.  There, 
stockholders  at  the  annual  meeting  elect  a  professional  accoimt- 
ant  as  the  auditor  of  the  company  for  the  ensuing  year.  His 
report  is  made  to  the  stockholders,  not  to  the  officers  and  directors. 

A  corporation  which  has  nothing  to  hide  cheerfully  sends  its 
balance  sheet  to  its  stockholders,  and  if  the  latter  exhibit  enough 
interest  in  the  matter  to  request  that  the  certificate  of  a  pro- 
fessional auditor  be  attached,  such  request  will  probably  be 
complied  with.  Therefore,  in  every  possible  and  dignified  way, 
the  auditor  should  impress  upon  stockholders  the  many  advan- 
tages to  themselves  of  such  procedure. 

The  value  of  the  pubHcity  given  to  audited  accounts  cannot  be 
overestimated.  In  a  general  way  the  uninformed  public  believes 
all  corporations  to  be  making  unreasonable  profits,  particularly 

^  In  New  York  State  legal  protection  is  made  possible  by  the  following 
provision  in  the  statutes: 

Financial  Statement  to  Stockholders. — Stockholders  owning  five  per 
centum  of  the  capital  stock  of  any  corporation  other  than  a  moneyed  cor- 
poration, not  exceeding  one  hundred  thousand  dollars,  or  three  per  centum 
where  it  exceeds  one  hundred  thousand  dollars,  may  make  a  written  request 
to  the  treasurer  or  chief  fiscal  officer  thereof,  for  a  statement  of  its  affairs, 
under  oath,  embracing  a  particular  account  of  all  its  assets  and  liabilities, 
and  the  treasurer  shall  make  such  a  statement  and  deliver  it  to  the  person 
presenting  the  request  within  thirty  days  thereafter,  and  keep  on  file  for 
twelve  months  thereafter  a  copy  of  such  statement,  which  shall  at  all  times 
during  business  hours  be  exhibited  to  any  stockholder,  demanding  an  exami- 
nation thereof;  but  the  treasurer  or  such  chief  fiscal  officer  shall  not  be  re- 
quired to  deliver  more  than  one  such  statement  in  any  one  year.  The 
supreme  court,  or  any  justice  thereof,  may  upon  application,  for  good  cause 
shown,  extend  the  time  for  making  and  delivering  such  certificate.  For 
every  neglect  or  refusal  of  the  treasurer  or  other  chief  fiscal  officer  thereof  to 
comply  with  the  provisions  of  this  section  he  shall  forfeit  and  pay  to  the 
person  making  such  request  the  sum  of  fifty  dollars,  and  the  further  sum  of 
ten  dollars  for  every  twenty-four  hours  thereafter  until  such  statement  shall 
be  furnished."  (Stock  Corporation  Law,  Section  69.)  Leading  case,  French 
t>.  McMillan,  43  Hun  188  (1887). 


ADVANTAGES  OF  AN  AUDIT  37 

all  corporations  which  in  any  way  attempt  to  serve  the  public. 
For  instance,  in  New  York  City,  the  taxicab  companies  were 
attacked  in  the  newspapers  and  one  ordinance  after  another  was 
passed  regulating  fares,  all,  of  course,  reducing  them.  In  a  few 
years,  at  least  two  millions  of  dollars  were  lost  by  three  or  four  of 
these  companies.  During  that  time  they  did  not  make  periodical 
statements  to  their  stockholders  nor  to  the  pubHc  setting  forth 
their  losses  and  the  reasons  therefor.  For  some  mysterious  reason 
publicity  was  shunned.  It  is  about  as  certain  as  anything  can  be 
that  if  certified  statements  of  operations  had  been  secured  and 
sent  to  the  newspapers  annually,  a  far  different  state  of  public 
opinion  would  have  resulted. 

Corporations  which  are  secretive  about  their  accounts  or 
which  issue  statements  not  certified  to,  have  only  themselves  to 
blame  if  they  are  made  the  victims  of  hostile  legislation. 

Generally  speaking,  railroads  and  other  pubHc  utilities  have 
not  permitted  professional  auditors  to  pass  upon  their  accounts. 
When  rising  costs  of  operation  forced  the  companies  to  ask  for 
higher  rates,  the  requests  were  frequently  refused  on  the  ground 
that  the  utilities  made  outrageous  profits  in  the  past  and  that 
such  profits  should  be  used  to  tide  them  over  the  period  of  high 
operating  costs.  Few  utihties  have  made  unreasonable  profits,  but 
for  some  reason  the  pubHc  will  not  beheve  such  a  statement.  If  a 
proper  system  of  pubHcity  had  been  adopted  and  frequent  audited 
statements  had  been  issued,  a  different  feeling  would  now  exist. 

7.  Sale  of  a  Business. — The  author  has  had  several  ex- 
periences in  which  it  was  demonstrated  that  if  periodical  state- 
ments of  the  results  of  operations,  duly  certified  to  by  responsible 
auditors,  had  been  available,  large  enterprises  would  have 
changed  hands  in  a  few  days;  but,  such  statements  not  being 
promptly  available,  the  sales  were  not  made. 

In  the  case  of  a  corporation  in  which  the  president  owned  a 
controlling  interest,  he  was  offered  two  and  a  half  million  dollars 
for  control,  subject  to  examination  by  accountants.   He  accepted. 


38  AUDITING— GENERAL  PRINCIPLES 

When  an  attempt  was  made  to  ascertain  the  earnings  for  a  period 
of  years  it  was  found  that  no  accurate  records  had  ever  been  kept. 
Large  profits  had  been  realized,  but  this  was  known  only  because 
the  money  was  in  the  bank.  Physical  inventories  had  never  been 
taken  and  book  inventories  had  not  been  kept.  At  the  time  of 
the  proposed  purchase  the  plant  was  operating  on  an  extensive 
scale,  but  as  no  cost  records  were  kept,  it  was  impossible  to 
determine  the  rate  of  profit  on  the  current  output.  The  deal  was 
called  off. 

The  president  complained  bitterly.  He  had  paid  enormous 
dividends,  which  he  knew  had  been  earned,  but  no  one  could 
determine  just  when  and  how,  and  the  condition  of  the  accounts 
cast  suspicion  on  the  whole  enterprise. 

Practically  all  business  men  look  forward  to  retiring  sooner 
or  later.  It  is  a  kindness  to  them  to  indicate  how  much  easier 
and  more  certain  it  will  be  for  them  to  accomplish  their  purpose 
if  they  can  produce  correct  certified  accounts  than  if  compelled 
to  depend  upon  unaudited  accounts,  which  may  fail  to  meet  the 
requirements  of  a  prospective  purchaser. 

8.  Recovery  for  Negligence. — The  final  advantage  of  an 
audit  (and  one  upon  which  perhaps  serious  differences  of  opinion 
may  exist  as  to  the  advisability  of  public  discussion)  is,  that  a 
client  who  suffers  loss  through  the  dishonesty  of  an  employee  may 
recover  an  equivalent  amount  from  the  auditor  if  it  can  be  shown 
that  the  latter  has  performed  his  work  in  a  grossly  negligent 
manner,  and  provided,  of  course,  that  the  defalcation  occurred 
during  the  period  covered  by  the  audit  and  continued  thereafter. 


CHAPTER   IV 

HOW  TO  BEGIN  AN  AUDIT 

The  importance  of  knowing  how  to  begin  an  audit  cannot  be 
overestimated.  The  terms  of  employment  are  more  or  less  gen- 
eral in  their  nature  and  the  scope  of  the  work  is  left  to  the  auditor. 
Many  practitioners  commence  the  work  before  they  have  a 
clearly  defined  line  of  procedure  in  their  own  minds.  It  is  ad- 
visable for  the  business  public  as  well  as  for  practitioners  to  con- 
sider various  possibilities  in  order  to  eliminate  useless  work. 

A  Preliminary  Program 

Based  on  personal  experiences  of  over  thirty  years,  the  authoi^I 
suggests  the  following  preliminary  program : 

I.  As  TO  THE  Client. — Uncertainty  sometimes  exists  as  to 
the  actual  client  whom  the  auditor  is  serving,  to  whom  he  is 
responsible,  and  who  will  pay  the  bill.  It  may  be  a  banker  or  a 
prospective  borrower,  a  corporation  or  a  dissatisfied  stockholder, 
a  trustee  in  bankruptcy  or  the  petitioning  creditors,  or  a  creditors' 
committee,  a  municipality,  a  congressional  or  an  aldermanic 
committee,  a  state  or  an  investigating  committee  of  the  legisla- 
ture. In  all  of  these  cases  and  many  more,  differences  of  opinion 
have  arisen  as  to  the  legal  status  of  the  client;  therefore  this  word 
of  caution  addressed  particularly  to  the  beginner  is  in  order : 

Fix  the  legal  status  of  the  client  before  work  is  commenced. 

In  a  New  York  case,  the  president  of  a  corporation  who  took 
no  active  part  in  the  management  of  the  business  except  occasion- 
ally to  preside  over  directors'  meetings,  contemplated  the  pur- 
chase of  the  stock  of  his  associate  stockholders  and  employed  a 
firm  of  accountants  to  audit  the  books.  The  books  of  the  cor- 
poration were  turned  over  to  the  accountants  for  that  purpose  by 

39 


40  AUDITING— GENERAL  PRINCIPLES 

the  treasurer  of  the  corporation,  who  made  the  statement  to  the 
accountant  that  it  must  be  understood  that  such  an  examination 
was  the  president's  personal  affair,  and  not  that  of  the  company. 
Upon  completion  of  the  work,  and  demand  for  payment,  which 
was  refused  by  the  corporation  (the  president  having  died)  an 
action  was  brought  ^or  the  amount  then  due.  The  court  held 
that  the  corporation  was  not  liable.  The  court  in  its  decision  said 
in  part:  *'The  right  of  third  parties  to  rely  on  the  apparent 
authority  of  corporate  officers  is  subject  to  the  condition,  that 
such  third  parties  have  no  knowledge  of  a  limitation  on  such 
authority.  In  this  case  we  think  the  notice  given  the  accountant 
that  the  audit  .  .  .  was  for  (the  president's)  personal  account 
.  .  .  was  notice  to  the  plaintiff.  "^ 

2.  Proper  Starting  Conditions. — Some  auditing  engage- 
ments have  ended  disastrously  for  the  auditors  because  the  work 
was  undertaken  blindly.  It  is  not  enough  that  someone  should 
say,  ''Here  are  certain  books  and  records;  I  want  them  audited 
and  a  report  made  to  me  of  what  they  contain."  The  cHent  may 
think  he  knows  what  he  wants,  he  may  be  financially  able  to  pay, 
and  to  a  yoimg  practitioner  the  temptation  to  jump  in  and  follow 
instructions  is  strong  indeed.  But  the  cKent  may  and  does  change 
his  mind  as  the  work  progresses,  and  even  if  the  instructions  are 
in  writing,  he  will  find  some  excuse  for  his  change  of  mind.  He 
may  still  be  able  to  pay,  but  he  may  not  want  to.  There  are 
several  notable  examples  of  work  done  along  the  lines  indicated 
for  which  the  bills  have  never^been  paid. 

Always  spend  some  time  with  the  client,  reviewing  the 
work  before  it  is  commenced.  Map  out  as  definite  a  program  as 
possible,  and  overstate,  rather  than  understate,  the  probable 
time  which  will  be  required.  The  client  may  have  a  vague  knowl- 
edge of  details,  but  he  should  know  pretty  well  what  the  work 
should  cover,  and  if  the  auditor  cannot  come  to  a  fairly  definite 


^  Ernst  et  al.  v.  Gary  Safe  Company,  113  Misc.  Rep.  620;  185  N.  Y.  Supp. 
168. 


HOW  TO  BEGIN  AN  AUDIT  41 

agreement  with  him  as  to  the  scope  and  extent  of  the  work,  the 
responsibility  of  making  good  is  placed  definitely  on  the  auditor. 

A  few  hours'  talk  of  this  nature  may,  subsequently,  eliminate 
many  days  of  useless  work — useless  because  there  may  have  been 
a  mistaken  idea  as  to  the  results  wanted;  or  the  results  striven  for 
might  be  very  valuable  and  interesting  if  the  work  could  be  com- 
pleted as  originally  planned. 

In  most  cases  the  auditor's  wide  experience  enables  him  to 
know  better  than  the  client  just  what  should  be  done,  and  what 
may  be  safely  omitted,  but  this  does  not  relieve  an  auditor  from 
his  obligation  to  assure  himself  whether  in  the  particular  case 
before  him  the  client's  intimate  knowledge  of  the  business  does 
not  justify  him  in  indicating  the  general  lines  along  which  the 
audit  should  be  made. 

A  full  and  frank  talk  with  a  client  cannot  do  any  possible 
harm  and  may  insure  co-operation  and  harmony,  which  might  be 
lacking  if  the  auditor  shows  too  much  of  a  disposition  to  run  the 
whole  job  himself. 

3.  Co-operation  of  Client's  Staff. — A  successful  auditor 
told  the  author  recently  that  in  every  audit  he  endeavored  to 
attract,  instruct,  and  convert  the  office  staff,  and  in  so  doing  he 
not  only  made  his  own  work  pleasanter  and  more  satisfactory  in 
a  professional  way,  but  that  he  also  made  them  co-workers  with 
him;  and  in  many  ways  they  aid  the  growth  of  a  proper  opinion 
of  the  value  of  the  work  of  the  public  accountant.  Many  in- 
stances are  known  where  auditors  have  antagonized  an  office 
staff  and  sent  them  out  to  an  extensive  acquaintance  charged 
with  a  desire  to  criticize  most  unfavorably  not  only  the  offending 
auditor  (which  would  not  be  unfair),  but  also  professional  auditors 
as  a  class.  On  the  other  hand,  some  very  large  engagements  have 
resulted  directly  from  a  word  of  commendation  to  others  from  a 
bookkeeper  or  clerk  who  has  had  a  satisfactory  experience  with 
the  auditor  of  his  accounts. 

All  auditors  of  experience  agree  that  the  majority  of  men  are 


42  AUDITING— GENERAL  PRINCIPLES 

honest — not  a  mere  majority  only,  but  most  men  are  honest. 
Furthermore,  most  men  are  sensitive  about  having  their  honesty 
questioned  even  indirectly.  The  successful  auditor  does  not  con- 
duct himself  in  such  a  manner  as  to  indicate  to  anyone  that  sus- 
picion exists.  He  must  radiate  his  behef  in  the  good  faith  and 
honesty  of  purpose  of  those  whose  accounts  he  is  examining;  but 
he  should  be  none  the  less  thorough  and  he  will  just  as  surely  land 
any  guilty  man. 

The  honest  man  is  also  sensitive  to  criticism  of  his  work. 
Here  the  auditor's  task  is  harder,  because  the  duty  to  one's  client 
must  be  placed  above  everything  else;  and  while  it  is  sometimes 
impleasant  to  condemn  carelessness  and  mistakes  on  the  part  of 
the  office  staff,  yet  if  it  is  eyident  that  the  client's  business  is 
suffering  therefrom,  failure  to  report  actual  conditions  is  a  breach 
of  professional  duty. 

But  the  auditor  who  prepares  his  report  and;sends  it  in  to  the 
cHent  without  considering  its  effect  on  the  office  staff  may  be 
doing  a  positive  injury  to  his  client  as  well  as  to  himself.  The 
clerk  whose  work  is  criticized  may  be  one  of  the  most  valuable 
on  the  staff.  His  merits  may  vastly  outweigh  his  shortcomings; 
yet  if  he  is  sensitive  he  may  resign  forthwith,  thus  weakening  the 
client's  organization  and  subjecting  the  auditor  to  the  wrath 
which  he  in  a  measure  deserves. 

Or  again,  the  clerk  or  clerks  whose  work  is  criticized  may  not 
resign,  but  being  in  the  confidence  of  the  client  and  having  his 
ear  every  day,  may  easily  offset  all  of  the  good  effect  which  the 
criticisms  and  suggestions  might  have,  and,  in  addition,  prej- 
udice the  client  against  the  further  employment  of  the  auditor. 
Naturally,  the  auditor  is  not  informed  as  to  what  is  taking  place, 
and  if  his  services  are  not  called  for  when  another  audit  is  due,  he 
is  ignorant  of  the  true  reason  for  the  decision  against  him. 

Hundreds  of  business  men  have  retained  a  professional  audi- 
tor once  as  an  experiment,  because  they  had  been  told  it  was  the 
proper  thing  to  do,  and  would  have  become  regular  clients  had 
the  auditor  been  able  to  secure  the  syrnpathy  and  co-operation  of 


HOW  TO  BEGIN  AN  AUDIT  45 

the  office  staff.  Who  can  blame  a  busy  man,  necessarily  depend- 
ent upon  an  organization  of  trusted  employees,  for  heeding  their 
opinion  of  an  auditor? 

4.  Tact  Required. — The  auditor  need  not  stultify  himself  by 
failure  to  criticize.  As  a  matter  of  fact,  an  honest  staff  resents 
gratuitous  commendation  if  they  know  it  is  not  deserved.  All 
they  want  is  a  square  deal.  In  practically  all  cases  the  methods 
in  force  were  initiated  by  the  client  himself  or  by  the  predecessors 
of  the  present  staff.  They  are  simply  following  precedent  or 
instructions  and  should  not  be  personally  blamed  for  unsatis- 
factory methods  or  results. 

Let  the  auditor  proclaim  his  gospel  of  helpfulness  and  ask  for 
co-operation  in  the  interest  of  the  staff  and  in  that  of  the  cHent. 
Let  him  demonstrate  quietly  that  he  knows  more  than  they  do, 
but  let  it  be  done  unobtrusively.  Show  them  that  failure  to  be 
up-to-date  is  detrimental  to  success,  and  that  modern  methods 
must  justify  themselves.  Get  them  interested  and  ask  their  help 
in  preparing  an  unbiased  report  on  actual  conditions,  and  obtain 
their  approval  of  the  suggested  changes.  If  this  spirit  prevails 
throughout  the  audit  the  client  will  be  benefited,  the  office  staff 
will  be  enthusiastic  over  the  innovation,  and  the  auditor  will 
receive  a  unanimous  invitation  to  come  again. 

5.  Compensation  Must  Depend  on  Service  Rendered. — 
The  professional  accountant  offers  his  services  to  the  business 
public  as  an  adviser  as  well  as  an  analyst  or  auditor;  therefore  it  is 
obvious  that  the  matter  of  compensation  and  status  cannot  be 
determined  as  it  can  in  those  occupations  where  output  or  results 
can  be  measured.  You  cannot  gauge  an  output  of  brains  as  you 
can  a  stated  amoimt  of  manual  labor. 

Great  harm  has  been  done  to  the  profession  by  certain  ad- 
vertisers who,  for  the  purpose  of  selling  correspondence  courses 
in  accountancy,  have  exaggerated  the  compensation  of  profes- 
sional accountants.    There  is  no  reason  why  the  profession  should 


44  AUDITING— GENERAL  PRINCIPLES 

be  better  paid  than  any  other  which  serves  the  public  to  an 
equal  degree.  The  implication  in  these  advertisements  that 
there  is  some  fixed  scale  of  fees  which  an  accountant  can 
charge  is  more  or  less  correct,  and  it  is  imfortunate  that  such 
is  the  case,  for  it  tends  to  place  the  profession  on  a  par  with  day 
laborers. 

If  all  accountants  are  to  charge  alike  for  their  services,  where 
is  the  incentive  to  excel  and  what  kind  of  profession  would  it  be 
if  there  were  no  premium  on  ability  and  experience?  The  best 
lawyers  and  the  best  doctors  sometimes  charge  lower  fees  for  the 
same  service  than  less  experienced  and  less  competent  practi- 
tioners, but  such  reduction  is  none  the  less  professional. 

So  with  accountants,  as  time  goes  on  there  will  be  less  and 
less  uniformity  in  charges,  and  the  more  skilful,  capable,  ex- 
perienced accountant  will  not  consider  it  necessary  to  place  a 
fixed  per  diem  rate  on  his  services.  Nevertheless,  under  present 
conditions  per  diem  rates  yield  the  greatest  compensation.  Where 
flat  fees  are  charged  it  almost  always  means  that  some  concession 
has  been  or  will  be  made  in  the  per  diem  rate,  so  that  the  auditor 
who  can  always  command  hberal  day  rates  will  reap  the  greatest 
financial  reward. 

The  one  good  argument  for  a  stated  fee  (and  it  is  a  strong  one) 
is  that  the  client  prefers  it  in  perhaps  nine  cases  out  of  ten.  Pro- 
fessional men  should  place  the  adherence  to  the  ethics  of  their 
profession  and  the  satisfaction  of  their  chents  above  pecuniary 
gain.  Therefore,  if  the  work  is  fully  and  properly  performed  and 
the  client  is  satisfied,  the  method  or  rate  of  compensation  should 
be  secondary,  and  a  round  fee,  imder  such  circumstances,  is  quite 
as  ethical  as  a  per  diem  rate. 

If  the  fee  has  not  been  arranged  beforehand  and  htigation  is 
necessary,  the  auditor  will  receive  the  usual  professional  fee, 
provided,  of  course,  that  witnesses  can  be  obtained  to  testify 
that  the  work  measures  up  to  the  usual  standard  of  professional 
work  and  that  the  fee  is  a  reasonable  one. 

Juries,  however,  are  apt  to  be  more  unreasonable  than  clients 


HOW  TO  BEGIN  AN  AUDIT  45 

with  respect  to  professional  charges,  and  the  rule  of  arranging 
fees  beforehand  should  not  be  deviated  from  except  in  special 
cases. 

Prior  to  19 14  an  inquiry  into  the  actual  rates  charged  by  ac- 
countants was  conducted  in  New  York  City.  There  was,  of 
course,  a  wide  divergence  between  the  fees  named  by  well-es- 
tabhshed  firms  having  a  large  clientele  and  the  accountant  just 
starting  in  practice.  The  result  of  the  inquiry  is  mentioned  here 
for  what  it  is  worth,  and  without  any  attempt  to  set  it  up  as  a 
standard  for  other  parts  of  the  country,  nor  even  for  accountants 
practicing  in  New  York  City. 

The  questions  and  answers,  with  slight  modifications  in  the 
form,  were  as  follows: 

Q.  What  is  the  maximum  rate  received  per  day,  and  for  what  class 
of  work? 

A.  $100  per  diem  was  the  maximum  rate  received,  and  that  only  for 
a  special  class  of  work,  such  as  an  investigation  calling  for  particularly 
expert  knowledge.  In  one  case,  however,  $250  per  day  was  charged  for  a 
few  days'  service. 

Q.     What  is  the  minimum  rate  per  day  received? 

A.     $10  per  day. 

Q.     What  is  a  fair  average  rate  for  accountants  of  the  highest  class? 

A.     $50  per  day. 

Q.  What  is  a  fair  average  rate  for  accountants  who  might  be  consid- 
ered as  not  of  the  highest  class? 

A.    $25  per  day. 

Q.  What,  in  your  opinion,  would  be  a  standard  rate  for  investigations 
requiring  first-class  ability,  as  a  minimum? 

A.    $25  per  day. 

Q.  What,  in  your  opinion,  should  be  the  rate  for  ordinary  audits  and 
examinations  not  requiring  the  highest  ability,  as  a  minimum? 

A.    $15  per  day. 

Q.  If  you  were  establishing  standard  rates,  taking  all  circumstances 
fairly  into  consideration,  what  rates  would  you  advise? 

A.  For  standard  rates  the  minimum  fee  for  the  man  in  charge  should 
be  $25  per  day;  for  ordinary  assistants,  $15 ;  and  for  juniors  used  in  clerical 
checking,  $10  per  day;  but  the  restriction  of  this  compensation  is  not  ad- 
vocated, especially  for  those  in  charge  of  work,  to  $25  per  day. 


46  AUDITING— GENERAL  PRINCIPLES 

Owing  to  world-wide  conditions,  the  foregoing  rates  have  been 
revised  considerably  and  if  brought  up  to  date  the  answers  would 
probably  quote  the  following: 

Seniors :  maximimi  $50,  minimum  I30. 
Juniors:  maximum  $30,  minimum  $20. 
With  the  amount  charged  for  the  principal  from  $50  to  $100 
per  day. 

In  the  legal  profession  contingent  fees  are  often  agreed  upon. 
In  the  accounting  profession  the  trend  is  decidedly  against  con- 
tingent fees.  One  of  the  rules  of  professional  conduct,  ap- 
proved by  the  Council  of  the  American  Institute  of  Accountants 
reads:  ''No  member  shall  render  professional  service  the  antici- 
pated fee  for  which  shall  be  contingent  upon  his  findings  and 
results  thereof." 

It  is  proper  that  the  auditor  should  avoid  even  the  appearance 
of  evil,  but  it  is  a  debatable  question  as  to  whether  this  rule  is  not 
so  strict  that  literal  compliance  therewith  is  impracticable.  If 
this  is  the  case,  the  rule  should  be  reframed  in  order  to  express 
properly  the  thought  that  it  is  always  wrong  for  an  auditor  to 
undertake  work  which  he  cannot  conscientiously  certify  to,  or  to 
submit  figures  which  may  reflect  his  prejudices  rather  than  his 
honest  convictions.  As  a  matter  of  fact,  auditing  work  may  be 
performed  upon  the  basis  of  a  contingent  fee,  the  propriety  or 
honesty  of  which  can  no  more  be  questioned  than  if  it  were  under- 
taken upon  a  basis  of  per  diem  rates. 

In  the  opinion  of  the  author,  the  auditor  should  subject  each 
engagement  to  scrutiny  to  discover  any  possible  reasons  why  he 
should  not  undertake  it.  Work  which  involves  his  integrity 
should  always  be  declined.  The  author  knows  of  one  case  when  a 
contingent  fee  was  in  every  way  ethical.  It  is  possible  that  others 
may  arise.     The  Institute  should  make  its  rule  more  flexible. 

6.  As  TO  Where  the  Work  Is  Done. — This  question  re- 
ceives but  Httle  consideration  in  the  usual  audit  until  it  is  too  late 


HOW  TO  BEGIN  AN  AUDIT  47 

to  make  a  change.  Most  audits  are  made  in  the  office  where  the 
general  books  of  account  are  written  up.  Provided  there  are 
ample  space,  adequate  light,  satisfactory  and  sanitary  working 
conditions  such  as  pure  air,  etc.,  and  reasonable  freedom  from 
interruption  by  unauthorized  persons,  this  is  the  ideal  place. 

When  the  audit  is  being  aranged  for,  all  of  these  points  can 
be  discussed.  Few  cHents  will  hesitate  to  modify  or  improve 
existing  conditions  in  order  that  the  audit  work  may  be  performed 
under  favorable  auspices.  But  if  this  matter  is  left  in  abeyance 
until  the  audit  is  actually  commenced,  changes  are  almost  im- 
possible to  effect,  or  if  not  impossible,  the  auditor  usually  deems 
it  inadvisable  to  open  up  the  subject.  Therefore,  stipulate  for  the 
best  possible  working  conditions  before  work  is  commenced. 

Wherever  possible,  the  auditor  should  make  a  tour  of  inspec- 
tion before  commencing  his  audit,  accompanied,  if  it  can  be  ar- 
ranged, by  an  executive  of  the  cHent's  office.  This  inspection 
should  enable  him  to  become  familiar  with  some  of  the  conditions 
pecuUar  to  the  concern  whose  accoimts  he  is  about  to  examine. 
The  knowledge  thus  gained  will  enable  him  to  lay  out  his  audit 
program  to  better  advantage,  and  it  will  tend  to  simphfy  and 
expedite  his  work. 

7.  Working  Papers. — It  may  sound  paradoxical,  but  the 
time  to  arrange  working  papers  is  before  the  actual  work  of  the 
audit  begins. 

The  most  important  point  to  emphasize  is  that  the  more  in- 
experienced an  auditor  is,  the  more  working  papers  he  produces, 
so  that  the  student  or  practitioner  who  aspires  to  a  high  place  in 
his  profession  will  avoid  all  ujinecessary  compilations  and  com- 
ments. He  should  try  to  settle  his  doubts  relative  to  questionable 
transactions  immediately,  for  the  majority  of  his  questions  will  be 
answered  satisfactorily;  he  should  eliminate  the  copying  of  trial 
balances,  statements,  etc.,  unless  he  has  a  clear  idea  as  to  their 
ultimate  use;  and  he  should  ruthlessly  destroy  his  papers  as  soon 
as  their  value  is  questionable. 


48  AUDITING— GENERAL  PRINCIPLES 

It  is  a  pity  that  the  Hmits  of  this  book  make  it  impracticable 
to  include  detailed  illustrations  of  how  things  should  be  done  and 
how  they  should  not  be  done.  Perhaps  the  assertion  that  the  skill 
of  an  accountant  can  always  be  ascertained  by  an  inspection  of 
his  working  papers  is  too  sweeping,  but  it  holds  good  in  so  many 
cases  that  it  may  as  well  be  called  a  general  rule,  and  therefore 
prospective  auditors  should  take  notice  that  some  day  they  may 
be  so  judged. 

If  the  professional  man  were  as  careful  with  his  tools  as  is  the 
mechanic,  he  would  do  better  work  and  he  would  save  himself 
many  hours  of  dupHcated  labor.  An  accountant  must  be  the 
personification  of  order  and  system;  his  business  is  to  criticize 
careless  methods  in  others  and  to  construct  proper  systems  for 
those  who  have  none.  Therefore  he  must  convey  the  impression 
that  he  appreciates  order  and  good  methods  and  be  able  to  demon- 
strate this  by  an  exhibition  of  the  highest  degree  of  perfection  in 
his  own  working  papers. 

Stationery  is  cheap,  far  cheaper  in  proportion  than  the  imple- 
ments used  by  mechanics,  yet  many  accountants  use  a  scrap  of 
paper  or  the  back  of  an  envelope  to  make  a  record  in  connection 
with  an  audit,  when  the  items  so  noted  are  important  enough  to 
be  set  down  in  an  orderly  way  on  a  whole  sheet  of  specially  ruled 
paper.  It  really  seems  absurd  to  devote  much  space  to  this 
matter,  and  it  is  only  because  there  is  such  a  widely  prevalent 
looseness  in  this  respect  that  emphasis  is  placed  on  the  use  of  good 
stationery  and  on  always  having  plenty  of  it  available. 

An  accountant  or  a  bookkeeper  should  have  on  hand  at  all 
times  a  complete  assortment  of  specially  ruled  paper  of  all  sizes. 
Let  him  consider  this  as  part  of  his  plant,  if  need  be,  because  a 
small  expenditure  will  secure  a  large  supply  of  paper.  The  special 
rulings  should  cover  every  form  for  which  there  may  be  the 
slightest  call. 

As  to  money  columns,  paper  should  be  ruled  with  from  three 
to  eighteen  columns.  The  former  will  be  the  most  used,  but  there 
is  a  constant  call  for  the  latter.    Then,  of  course,  ledger-ruled 


HOW  TO  BEGIN  AN  AUDIT  49 

paper  will  frequently  be  used,  and  it  is  very  desirable  to  have 
ledger  paper  with  two  money  columns  on  both  sides.  The  paper 
should  be  put  up  in  pads  of  fifty  sheets  each. 

In  commencing  an  audit,  a  full  assortment  of  paper,  together 
with  various  colored  pencils  or  ink,  etc.,  should  be  gathered  to- 
gether and  carried  preferably  in  a  stout  leather  portfolio  having  a 
first-class  lock  on  it  and  containing  convenient  pockets  for  papers, 
pencils,  rubber  stamps,  etc.  Is  it  not  obvious  that  a  client  or  a 
chent's  clerk  has  more  respect  for  an  auditor  who  is  fully  equipped 
than  for  a  man  who  is  compelled  to  borrow  first  a  sheet  of  paper 
and  next  a  pencil  in  order  to  record  details  of  the  petty  cash  as 
counted?    First  impressions  are  lasting. 

The  professional  auditor  cannot  afford  to  start  wrong,  since  he 
does  not  have  any  opportunity  to  conceal  his  incompetency. 
Stock  up,  therefore,  and  keep  stocked  up,  for  a  few  extra  dollars 
invested  in  a  big  supply  of  stationery  is  the  greatest  possible  help 
to  the  young  practitioner.  Having  the  paper,  use  it.  That  is, 
do  not  even  try  to  economize,  for  it  is  not  safe  to  temporize  and 
think  that  a  particular  memorandum  is  unimportant  and  there- 
fore just  as  well  recorded  on  a  scrap  as  on  a  whole  sheet  which 
may  have  cost  a  quarter  of  a  cent. 

There  should  be  an  absolute  rule  strictly  adhered  to,  for- 
bidding the  writing  of  more  than  one  class  of  errors  on  the  same 
sheet  of  paper.  The  reason  for  this  is  evident.  The  work  covered 
is  assumed  to  be  a  test  only,  and  no  one  can  tell  how  many  errors 
may  develop  if  additional  verification  is  required.  It  is  almost 
criminal  for  an  accountant  to  write  and  rewrite  and  classify  and 
reclassify  his  memoranda  during  the  course  of  an  audit,  when  every 
bit  of  the  rewriting  and  reclassification  could  have  been  avoided 
by  using  one  sheet  of  paper  for  each  class  of  errors  or  queries. 

An  auditor  who  is  careless  about  his  working  papers  will  vainly 
attempt  to  make  sense  out  of  his  notes.  How  is  it  possible  for 
such  a  man  to  write  a  report  of  the  greatest  possible  value  to  his 
client?  Even  if  he  finally  deciphers  all  of  his  notes,  he  makes  so 
much  trouble  for  himself  that  in  consequence  thereof  he  writes  his 

VOL.  I — 4 


50  AUDITING— GENERAL  PRINCIPLES 

report  in  a  troubled  and  irritated  frame  of  mind.  His  careless 
style,  of  course,  permeates  the  text. 

Consider  the  case  of  an  auditor  who  takes  the  trouble  to  pro- 
vide himself  with  an  ample  supply  of  paper,  and  who  uses  a  separ- 
ate sheet  for  each  class  of  error,  suggestion,  or  cormnent.  When 
he  is  ready  to  write  the  report  he  merely  sorts  his  working  papers, 
and  with  full  notes  before  him,  with  no  irrelevant  matters  con- 
stantly interrupting  his  train  of  thought,  simply  proceeds  in  an 
orderly  manner  to  the  close.  Is  it  worth  while?  Who  has  the 
better  chance  for  another  engagement  from  the  cHent  so  served? 

Auditors  often  need  exact  copies  of  papers,  signatures,  etc., 
for  future  reference  or  for  court  proceedings.  Usually  it  is  not 
possible  to  retain  the  cHent's  copies.  In  such  cases  the  auditor 
will  find  it  to  his  advantage  to  have  photostats  made.  They  can 
be  secured  in  a  few  hours  and  are  not  expensive. 

8.  Permanent  Filing  of  Working  Papers. — ^After  a  report 
has  been  written  great  care  must  be  taken  to  file  the  working 
papers  intelligently  and  according  to  a  well-laid-out  and  thor- 
oughly understood  plan;  otherwise  serious  inconvenience  may  be 
sustained  on  subsequent  occasions  when  a  particular  schedule  or 
reconciUation  sheet  is  required  in  a  hurry.  A  plan  which  has  been 
followed  with  success  is  the  following: 

Commencing  with  the  balance  sheet  submitted  to  the  client, 
each  item  thereon  is  assigned  a  letter.  For  instance,  if  ''Plant" 
is  the  first  item  among  the  assets,  the  letter  A  is  assigned  thereto. 
Each  schedule  relating  to  plant  is  marked  Ai,  A2,  A3,  etc.,  and  all 
papers  containing  information  bearing  thereon  are  grouped 
accordingly. 

The  same  plan  appHes  to  the  income  amount  and  to  any  other 
schedules  having  numerous  supporting  papers. 

When  the  single  letters  are  exhausted,  double  letters  may  be 
used,  as,  AA,  BB,  etc.  Variations  of  this  plan  will  suggest  them- 
selves to  the  auditor  who  has  had  difficulty  in  locating  working 
papers. 


HOW  TO  BEGIN  AN  AUDIT  5I 

A  draft  of  such  a  scheme  of  indexing  working  papers  is  given 
below: 

Pages 


A 

Draft  of  Report 

B 

Balance  Sheet 

C 

Earnings  and  Expense  Statement 

D 

.    Other  Report  Schedules 

E 

Trial  Balance 

F 

Adjusting  Entries 

G 

Assets: 

GA 

Cash  and  Bank  Certificates 

GB 

U.  S.  Obligations 

GC 

Notes  Receivable 

GD 

Accounts  Receivable  and  Reserve 

GE 

Inventories 

GF 

Investments 

GG 

Deferred  Expense 

GH 

Plant  and  Equipment  and  Reserve 

GJ 

Patents  and  Good-Will 

GK 

Other  Assets 

GL 

GM 

H 

Liabilities  and  Capital: 

HA 

Notes  Payable 

HB 

Accounts  Payable 

HC 

Accruals 

HD 

Reserve  for  Taxes,  etc. 

HE 

Mortgages 

HF 

Other  Liabilities 

KG 

Capital  Stock 

HH 

Surplus 

HJ 

HK 

J 

Income  Accounts 

K 

Miscellaneous  Data 

L 

Comments — Minutes,  etc. 

M 

Tax  Matters 

N 

Correspondence 

0 

P 

52  AUDITING— GENERAL  PRINCIPLES 

9.  Familiarity  with  System  in  Use. — During  the  auditor's 
early  training  he  has  an  opportunity  to  acquire  special  knowledge 
regarding  many  lines  of  commercial  activity,  so  that  many 
of  his  future  engagements  will  cover  undertakings  the  special 
features  of  which  will  be  familiar  to  him.  It  is  impossible,  how- 
ever, for  any  auditor  to  have  experience  in  every  line  of  business, 
and  engagements  are  sometimes  made  to  audit  accounts  of  which 
he  has  no  technical  or  special  knowledge.  He  is  not  expected  to 
have  such  special  knowledge,  but  he  should  explain  that  the  fun- 
damentals of  all  businesses  are  similar  and  that  he  is  thoroughly 
versed  therein. 

An  admission  of  his  unfamiliarity  wins  greater  respect  than 
does  an  attempt  to  conceal  his  ignorance;  progress  cannot  be 
made  without  asking  many  questions,  and  it  does  not  take  a 
client  long  to  discover  ignorance  if  an  attempt  is  made  to  conceal 
it.  In  any  event,  and  notwithstanding  long  experience  with  the 
same  class  of  business,  the  auditor  should  ask  questions  about  the 
personnel  and  the  special  features  of  the  business  under  review. 

Local  conditions  and  peculiarities  sometimes  produce  strange 
results,  and  the  auditor  finds  it  easy  to  acquire  a  broad  knowledge 
of  many  things  during  his  preliminary  conferences  which  would 
take  far  more  time  to  acquire  later.  The  client  and  his  staff  ex- 
pect to  be  asked  a  lot  of  questions  (inteUigent  and  tactful  ones,  of 
course)  at  first,  and  the  wise  auditor  makes  copious  notes  of  the 
information  so  derived.  The  client  is  likely  to  volunteer  the  his- 
tory of  his  hfe  and  the  progress  of  his  business  in  great  detail. 
Advantage  should  be  taken  of  such  an  opportunity  to  grasp  the 
technical  points  of  the  business.  Later  it  may  be  difficult  to  catch 
the  client  in  the  same  frame  of  mind. 

The  auditor  may  be  asked  whether  he  can  make  a  satisfactory 
audit  of  single-entry  books.  Of  course  there  is  no  difference  at  all 
so  far  as  auditing  principles  are  concerned. 

In  single-entry,  as  in  double-entry  systems,  the  auditor  should 
see  that  all  assets  which  should  be  on  hand  are  properly  accounted 
for;    that  all  income   which   should  have    been   recorded    is 


HOW  TO  BEGIN  AN  AUDIT  53 

found  to  be  in  order;  and  should  apply  all  of  the  general  principles 
of  auditing.  Single-entry  books  do  not  readily  lend  themselves  to 
tests  and  automatic  checks  as  do  double-entry  records,  more 
details  must  be  verified,  and  there  are  difficulties  in  the  way  of 
preparing  satisfactory  balance  sheets  and  income  statements. 
But  these  are  not  matters  which  require  special  treatment  in 
this  book. 

10.  Schedules  of  Books,  Records,  and  Names  of  Clerks. — 
A  mastery  of  the  general  system  in  use  includes  a  comprehensive 
knowledge  of  the  books  and  records  which  contain  the  trans- 
actions of  the  business  under  audit.  Books  of  accoimt  are  the 
histories  of  business  enterprises.  Since  a  history  is  not  complete 
unless  it  records  an  unbroken  narrative  of  facts,  the  auditor 
must  determine  whether  or  not  there  is  such  a  continuous  record 
of  the  transactions  of  the  business  in  the  books  submitted  to 
him. 

The  time  to  determine  this  is  before  the  audit  begins,  and  at  the 
time  of  the  inquiry  a  full  description  of  the  records  should  be  made 
and  the  names  of  the  clerks  responsible  therefor  should  be  care- 
fully noted.  These  names  will  be  needed  subsequently  and  when 
reporting.    It  arouses  suspicion  to  ask  for  names  when  needed. 

In  England  it  is  customary  in  most  cases,  and  compulsory  in 
others,  for  the  auditor  to  be  suppHed  with  a  list  of  the  books  in 
use.  In  this  country  the  advantage  of  this  precaution  is  strangely 
neglected. 

No  book  should  be  listed  until  its  use,  or  abuse,  is  fully  com- 
prehended. This  is  a  favorable  opportunity  to  fill  out  any  gaps 
in  the  complete  survey  of  the  business  which  the  auditor  must 
possess.  The  answers  to  the  preliminary  questions  and  a  detailed 
schedule  of  all  the  books  in  use  should  form  the  basis  for  an  in- 
telligent study  of  how  to  begin. 

1 1 .  Procedure  where  Previous  Audits  Have  Been  Made. 
— ^A  prominent  accountant  estimates  that  not  more  than  lo  per 
cent  of  the  business  concerns  of  this  country  have  their  accounts 


54  AUDITING— GENERAL  PRINCIPLES 

audited.  As  most  of  the  work  that  is  done  is  satisfactory,  it  is 
only  in  rare  cases  that  an  auditor  is  displaced. 

It  is  not  considered  ethical  for  one  auditor  to  supplant  another 
where  the  only  reason  for  the  change  is  that  of  remuneration.  If 
a  chent  expresses  dissatisfaction  with  the  work  of  one  auditor  and 
announces  his  intention  of  retaining  another,  there  can  be  no 
objection  to  the  appointment. 

Wherever  feasible,  the  auditor  should  receive  a  copy  of  his 
predecessor's  report,  but  if  it  cannot  be  had,  his  inspection  of  the 
books,  and  the  unsoHcited  remarks  of  the  client's  staff,  will  prob- 
ably indicate  the  extent  of  the  previous  audit. 

Of  course,  no  auditor  can  be  held  responsible  for  the  acts  or 
omissions  of  another  auditor,  but  he  has  no  justification  for 
blindly  following  the  procedure  of  a  previous  audit,  even  though 
the  client  requests  it.  Therefore  the  auditor  should  regard  all 
that  he  learns  of  his  predecessor's  work  as  information  purely 
supplemental  to  that  already  pointed  out  as  important,  and, 
weighing  all  together,  he  will  proceed  as  his  own  best  judgment 
dictates. 

Sometimes,  from  a  feeling  of  delicacy,  the  auditor  will  not 
insist  on  a  full  explanation  as  to  why  the  previous  auditor's  ser- 
vices have  been  dispensed  with.  In  view,  however,  of  the  fact 
that  auditors  have  been  displaced  for  failure  to  discover  specific 
weak  spots,  it  is  obvious  that  the  succeeding  auditor  is  at  a  dis- 
advantage without  this  knowledge,  so  that  in  all  cases  insistence 
on  an  explanation  can  do  no  harm  and  may  do  much  good. 

Shortly  stated,  a  safe  general  rule  is  to  proceed  as  if  no  pre- 
vious audit  had  been  made,  unless  complete  reports  of  another 
auditor,  in  whom  the  fullest  confidence  is  placed,  are  in  evidence, 
and  unless  there  is  no  question  as  to  the  reason  for  the  former 
auditor's  displacement. 

12.  Transactions  or  Developments  Occurring  Subse- 
quent TO  the  Date  of  the  Balance  Sheet. — To  what  extent 
should  an  auditor  be  governed  by  transactions  or  developments 


HOW  TO  BEGIN  AN  AUDIT  55 

occurring  subsequent  to  the  date  of  the  balance  sheet  but  prior  to 
the  date  of  the  certification?  In  stating  the  financial  position  of 
his  cHent  as  of  a  given  date,  should  he  look  at  the  past  and  shut 
entirely  from  view  the  prospects  for  the  future?  As  to  a  con- 
tingent liability,  if  any  development  occurring  after  the  date  of 
the  balance  sheet  but  prior  to  the  date  of  the  certification,  materi- 
ally modifies  or  possibly  removes  the  contingency,  that  develop- 
ment should  be  considered  in  the  preparation  of  the  balance  sheet. 
If  there  is  an  appreciable  change  in  market  prices  subsequent  to 
the  date  of  the  balance  sheet  but  prior  to  its  preparation,  the 
most  recent  fluctuations  should  be  considered  in  estimating  any 
contingent  loss.  In  brief,  an  audit  should  not  be  restricted 
altogether  to  transactions  which  have  been  concluded  or  have 
reached  a  precisely  determinable  status  at  the  date  of  the  balance 
sheet.    The  subject  will  be  more  fully  discussed  hereafter. 

13.  Final  Considerations:  Detailed  or  Balance  Sheet 
Audit? — It  may  be  inferred  that,  having  studied  the  matter  from 
so  many  standpoints,  and  particularly  after  having  had  a  final 
interview  with  the  client,  there  remains  nothing  to  do  but  to 
commence  the  actual  work. 

This,  however,  is  not  the  case.  Now  is  the  most  important 
time  for  calm  reflection.  Up  to  this  point  many  features  were 
more  or  less  uncertain.  The  chent's  understanding  of  the  state 
of  his  books  and  the  detail  therein  and  the  explanations  of  the 
clerks,  together  with  a  survey  of  the  books  themselves,  all  affect 
the  final  decision  as  to  what  should  be  done. 

Frequently  a  cHent  makes  the  broad  assertion  that  he  wants 
complete  and  detailed  examination  of  his  books.  Subsequent 
inquiry  may  develop  the  fact  that  a  first-class  system  of  internal 
check  exists,  or  that  the  transactions  are  so  numerous  that  a  de- 
tailed examination  is  quite  unnecessary.  Therefore  the  auditor 
should  reserve  final  decision  as  to  the  scope  of  his  work  until  he 
has  inspected  the  books  and  interviewed  those  in  charge  thereof. 

The  final  point  to  be  decided  is :  Shall  a  detailed  or  a  balance 


56  AUDITING— GENERAL  PRINCIPLES 

sheet  audit  be  made?  These  two  classes  of  audits  are  discussed 
fully  in  subsequent  chapters,  but  it  is  desirable  that  a  brief  survey 
of  each  be  made  at  this  point  in  order  that  we  may  now  com- 
pletely cover  every  phase  of  preparation  up  to  the  actual  physical 
work  of  the  audit  itself. 

In  dividing  audits  into  two  classes,  the  author  has  not  failed 
to  consider  another  class,  viz.,  ''cash"  audits.  The  title  is  a  mis- 
nomer, however,  because  many  attempts  to  limit  an  auditor  to  an 
examination  of  cash  records  have  either  resulted  in  an  incomplete 
and  unsatisfactory  task,  or  else  the  work  has  naturally  extended 
into  other  records  complementary  to  the  cash  account,  which,  of 
course,  are  vitally  necessary  to  a  proper  audit. 

A  professional  auditor  probably  should  not  refuse  point  blank 
to  make  a  so-called  cash  audit  when  requested  to  do  so,  but  he 
should  explain  fully  and  carefully  that  most  fraud  and  careless- 
ness He  in  the  transactions  which  do  not  reach  the  books;  that  the 
cash  account  in  itself  is  only  a  portion  of  a  system,  every  part  of 
which  depends  upon  and  works  into  the  others.  He  should  ex- 
plain that  to  accept  a  cash  book  as  correct  is  unwise,  because  it  is 
not  what  is  in  the  book  and  accounted  for  that  is  of  interest,  but 
rather  what  is  not  there,  evidence  of  or  clues  to  which  may 
possibly  be  found  in  the  other  books  and  records. 

Perhaps  the  safest  answer  for  the  auditor  to  give  is  the  state- 
ment that  there  is  no  such  thing  as  a  cash  audit,  and  follow  that 
statement  by  an  explanation  of  the  points  usually  covered  in  a 
detailed  audit  and  in  a  balance  sheet  audit. 

The  Detailed  Audit 

Whenever  a  complete  examination  is  desired  or  desirable,  a 
detailed  audit  should  be  made.  In  those  undertakings  having  no 
satisfactory  internal  check  the  detailed  audit  is  the  only  one  which 
covers  the  income  and  expenditures  for  the  period  under  audit. 
This  appHes,  therefore,  chiefly  to  small  enterprises;  but  since  the 
organizations  which  have  a  complete  system  of  internal  check  are 
in  the  minority,  the  auditor  will  in  many  cases  have  to  undertake 


HOW  TO  BEGIN  AN  AUDIT  57 

a  detailed  audit.  But  a  detailed  audit  in  the  sense  in  which  the 
term  is  used  here  does  not  contemplate  the  verification  of  every 
item  in  the  books. 

Not  many  years  ago  one  of  the  principal  features  of  every 
audit  was  the  inspection  and  verification  of  vouchers  for  cash 
payments.  In  many  instances  certificates  stated  without  reserve 
that  the  "accounts  have  been  audited  and  found  to  be  correct, " 
when,  as  a  matter  of  fact,  absolutely  nothing  was  done  but  to 
compare  certain  receipts  purporting  to  represent  payments  of 
cash  and  acknowledgments  thereof,  with  the  payment  side  of  the 
cash  book.  The  certificates  appearing  at  the  end  of  treasurers' 
statements  in  many  pubHshed  reports  of  charitable  and  religious 
institutions  show  just  such  a  state  of  afTairs. 

It  seemed  conclusive  to  many  people  that  if  a  cashier  or  a 
treasurer  can  furnish  a  voucher  for  every  item  of  cash  disburse- 
ment, there  simply  cannot  be  anything  wrong  with  the  accounts 
as  a  whole.  As  the  science  of  accounts  developed,  some  auditors 
were  not  satisfied  with  this,  and  they  supplemented  the  examina- 
tion of  the  vouchers  by  a  complete  verification  of  the  footings  and 
postings.  Having  done  this,  they  were  content,  and  felt  that 
great  strides  had  been  made  in  the  art.  Add  to  the  above  the 
checking  of  the  trial  balance  and  you  have  the  full  program  of  a 
large  percentage  of  audits — certainly  up  to  fifteen  or  twenty 
years  ago. 

Careful  consideration  of  a  large  number  of  defalcations  reveals 
the  fact  that  most  of  them  could  not  have  been  discovered  by  a 
verification  of  the  vouchers,  footings,  postings,  or  trial  balances. 
This  fact  does  not  eliminate  the  necessity  for  proper  attention  to 
such  work,  but  it  does  emphasize  the  greater  necessity  for  atten- 
tion to  the  work  which  experience  shows  is  productive  of  the  most 
satisfactory  results. 

An  auditor  must  at  all  times  study  and  think  and  appreciate 
the  need  of  preparing  all  of  his  plans  on  a  relative  scale.  Conceding 
the  obvious  conclusion  that  no  audit  can  or  should  embrace  a 
complete  verification  of  all  the  transactions  of  the  period  under 


58  AUDITING— GENERAL  PRINCIPLES 

review,  it  follows  that  the  process  of  elimination  must  proceed 
scientifically,  with  the  definite  goal  in  view  of  having  the  points 
covered  coincide  with  the  weak  spots. 

In  succeeding  chapters  the  author  outlines  the  procedure  for  a 
detailed  audit  in  which  proper  weight  is  given  to  the  verification 
of  the  routine  bookkeeping,  but  in  which  more  stress  is  laid  on 
other  phases  of  the  accounts  which  have  proved  to  be  those  most 
susceptible  to  fraud,  carelessness,  and  ignorance. 

Where  there  is  a  satisfactory  system  of  internal  check,  the 
auditor  is  not  expected,  and  should  not  attempt,  to  make  a  de- 
tailed audit.  The  word  ''satisfactory,"  however,  is  used  ad- 
visedly, for  more  than  one  large  corporation  with  a  comptroller 
and  a  force  of  staff  auditors  lacks  a  complete  system  of  internal 
check. 

When  the  staff  auditor  is  also  an  officer  in  the  business,  he  is 
seriously  handicapped  when  he  endeavors  to  check  the  records 
of  other  departments  of  the  organization.  There  are  so  many 
opportunities  to  impose  administrative  functions  upon  him  that 
shortly  his  supervisory  and  auditing  duties  become  hopelessly 
entangled.  Frequent  proof  of  the  existence  of  this  condition  of 
affairs  is  seen  in  the  discovery  of  defalcations  on  the  part  of  officers 
who  were  not  supposed  to  have  access  to  funds  or  securities. 

If  the  staff  auditor  is  a  clerk,  his  position  is  still  more  difficult 
to  maintain.  If  his  superiors  are  dishonest,  he  soon  has  to  choose 
between  dismissal  and  silence.  Therefore  the  mere  statement 
that  an  auditing  department  exists  is  not  enough  evidence  in  itself 
to  obviate  the  necessity  for  a  detailed  audit. 

Balance  Sheet  Audit 

If  the  auditor  has  satisfied  himself  that  the  system  of  internal 
check  is  adequate,  he  should  not  attempt  to  duplicate  work  which 
has  been  properly  performed  by  someone  else.  His  duty  then  is 
to  verify  the  assets  and  Habihties,  and  to  make  such  an  analysis 
of  the  income  account  as  will  enable  him  to  certify  that  it  has 
been  properly  stated. 


HOW  TO  BEGIN  AN  AUDIT  59 

But  there  is  a  much  wider  field  for  balance  sheet  auditing  than 
this.  Bankers  are  awakening  to  the  value  of  certified  statements 
from  borrowers  or  prospective  borrowers,  and  there  are  vast 
possibilities  in  this  class  of  work.  The  auditor  who  can  undertake 
these  engagements  with  a  clear  outline  of  what  is  to  be  covered, 
and,  more  important  still,  what  should  be  omitted,  has  a  tremen- 
dous advantage  over  the  auditor  who  does  not  appreciate  the 
peculiar  circumstances  which  surround  this  class  of  work.  Bal- 
ance sheet  audits  are  also  required  in  many  other  cases.  The 
author,  in  a  later  chapter,  attempts  to  set  forth  as  concisely  as 
possible  what,  in  his  opinion,  should  be  done  in  a  balance  sheet 
audit,  and  what  need  not  be  done,  and  what  should  not  be  done. 

Suggestions  to  Client's  Staff  before  Commencing  Work 

Where  an  audit  is  made  for  the  first  time,  the  client  usually 
informs  his  entire  staff  of  his  intentions,  so  that  there  is  no  possible 
chance  of  gaining  any  advantage  by  surprising  them. 

Then,  too,  it  may  be  that  the  audit  is  being  made  at  the  re- 
quest or  on  the  suggestion  of  one  or  more  of  the  staff.  This  occurs 
frequently  where  ambitious  bookkeepers  and  cashiers  realize 
that  the  methods  in  use  in  the  office  are  obsolete. 

If  the  auditor  desires  full  co-operation,  he  should  seek  an 
opportunity  to  ascertain  the  condition  of  the  books  and  records 
as  soon  as  possible  after  the  engagement  has  been  made.  He 
gains  nothing  whatever  by  jumping  in  before  the  books  are 
written  up  or  balanced. 


CHAPTER  V 

AUDIT  PROCEDURE 

The  author  at  one  time  believed  that  audit  notebooks,  "stand- 
ard" audit  programs,  and  "model"  forms  for  reports  were  of 
great  value;  but  after  using  them  for  some  years  it  became  evi- 
dent to  him  that  vigilance,  imagination,  and  the  independent 
thought  and  judgment  due  from  a  professional  practitioner,  are 
all  more  or  less  stifled  by  the  use  of  set  forms  and  set  directions. 
This  criticism  is  not  directed  at  the  program  which  an  auditor 
should  make  up  for  and  make  adaptable  to  each  audit.  This 
book  is  intended  to  be  an  audit  program  in  itself.  Unless  each 
program  is  written  up  specially,  the  temptation  to  repeat  what 
has  been  done  before  is  greater  than  the  average  auditor  can  with- 
stand. The  situation  is  not  unlike  bookkeeping  instruction.  At 
one  time  there  were  tens  of  thousands  of  school  boys  and  girls 
who  had  studiously  filled  in  journals  and  ledgers,  and  prepared 
trial  balances  and  other  statements  according  to  the  formulas  in 
the  textbooks,  without  being  able,  a  few  months  later,  even 
to  talk  intelligently  about  the  theory  of  bookkeeping.  The 
author  investigated  this  situation  and  decided  that  the  chief 
defect  was  in  the  explicit  directions  which  were  given.  It 
was  possible  to  memorize  most  of  the  rules,  and  the  students 
were  more  interested  in  their  examination  marks  than  in  the 
fundamentals. 

Program  of  Audit 

In  this  book  the  author  discusses  every  phase  of  auditing  but 
avoids  the  presentation  of  a  detailed  or  condensed  model  audit 
program.  The  material  is  all  here  but  those  who  desire  a  program 
must  prepare  one  for  themselves.    Nothing  can  be  more  harmful 

60 


AUDIT  PROCEDURE  6l 

to  students  than  the  exclusive  use  of  condensed  rules  of  procedure; 
practitioners  who  rely  on  programs  prepared  by  others  are  charge- 
able with  negligence  if  they  permit  fixed  rules  to  take  the  place  of 
independent  procedure.  There  is,  however,  no  objection  to  the 
use  of  a  summary  of  the  procedure  to  be  followed  in  most  audits, 
provided  the  summary  is  based  upon  and  used  with  discussions 
of  the  underlying  principles  of  auditing.  In  response  to  a  request 
from  the  Federal  Trade  Commission  and  later  from  the  Federal 
Reserve  Board,  a  committee  of  the  American  Institute  of  Accoun- 
tants in  191 7  prepared  a  memorandum  of  audit  procedure  which 
was  adopted  after  some  modification  and  pubhshed  by  the 
Federal  Reserve  Board.  ^  This  provides  a  flexible  balance  sheet 
audit  program.  It  also  should  meet  the  demands  of  those  who 
desire  an  inflexible  program,  because  the  entire  scope  of  an  audit 
is  covered  in  27  pages.  The  memorandiun  is  reproduced  in  full  in 
Appendix  A. 

Papers,  etc.,  Required  by  Auditor 

As  he  will  probably  be  asked  what  he  desires  in  the  way  of 
vouchers,  etc.,  the  following  memorandum  has  been  prepared. 
It  is,  of  course,  only  suggestive,  as  the  auditor  must  be  governed 
by  local  conditions: 

1.  A  correct  trial  balance,  as  of  the  date  the  audit  is  to  be 
made,  should  be  prepared.  If  not  ready  by  the  time  the  audit  is 
to  be  commenced,  the  auditor  should  have  a  conference  with  the 
chent  and  the  bookkeeper  and  determine:  (a)  if  the  work  is  to 
proceed  at  once;  (b)  if  it  is  to  be  postponed  until  the  differences 
are  located;  (c)  if  the  auditor,  acting  as  an  accountant,  is  to  locate 
the  errors. 

2.  Co'n trolling  accounts  in  the  general  ledger  should  be  in 
agreement  with  the  subsidiary  records;  if  not  in  agreement,  the 
matter  should  be  discussed  with  the  cHent  and  an  understanding 

'  The  author  was  chairman  of  the  committee,  which  was  composed  of 
representative  members  of  the  Institute.  In  addition,  accountants  with,  and 
meinbers  of,  the  Federal  Trade  Commission  and  the  Federal  Reserve  Board 
participated  in  the  discussions  and  made  many  helpful  suggestions. 


62  AUDITING— GENERAL  PRINCIPLES 

reached  as  to  whether  the  errors  are  to  be  located  or  allowed  to 
stand. 

3.  Schedules  of  notes  receivable  (whether  or  not  discounted), 
notes  payable,  bonds,  stocks,  etc.,  should  be  prepared. 

4.  Monthly  statements  from  creditors  should  be  preserved. 

5.  Paid  bank  cheques  and  all  other  vouchers  should  be  taken 
from  the  files  and  arranged  as  requested  by  the  auditor.  The 
auditor  should  not  disclose  the  use  he  proposes  to  make  of  the 
vouchers. 

6.  If  an  inventory  has  been  taken,  the  auditor  should  state 
to  what  extent  he  desires  the  certification  of  those  responsible 
therefor,  and  he  should  insist  on  the  original  sheets  being  pre- 
served and  submitted. 

7.  If  there  are  many  accounts  receivable,  it  may  be  wise  to 
request  that  they  be  divided  into  groups,  showing  all  those  over- 
due, etc.,  so  that  an  estimate  of  the  reserve  for  bad  debts  may 
readily  be  made. 

SYSTEM  OF  INTERNAL  CHECK 

Purpose  of  Internal  Check 

Reference  has  several  times  been  made  to  the  fact  that  the 
question,  whether  a  detailed  audit  should  be  made,  or  whether  a 
balance  sheet  audit  will  accomplish  the  desired  end,  depends  to  a 
considerable  extent  upon  the  existence  of  a  satisfactory  system  of 
internal  check. 

Such  a  system  consists  in  the  accounting  records,  methods, 
and  details  generally  of  an  establishment  being  so  laid  out  that 
no  part  of  the  account  or  procedure  is  under  the  absolute  and 
independent  control  of  any  one  person;  that,  on  the  contrary,  the 
work  of  one  employee  is  complementary  to  that  of  another;  and 
that  a  continuous  audit  is  made  of  the  details  of  the  business. 

Although  the  details  of  a  system  of  internal  check  vary  some- 
what in  different  cases,  the  following  general  points  usually  re- 
quire careful  attention. 


AUDIT  PROCEDURE  63 

Incoming  Mail. — Proper  provision  should  be  made  for  safe- 
guarding incoming  mail,  so  that  cash  received  will  reach  the 
cashier.  The  opening  and  handling  of  incoming  mail  should  be  in 
charge  of  some  responsible  person,  preferably  an  officer  of  the 
company. 

All  remittances  should  be  listed  and  the  Hst  subsequently 
compared  with  the  cash  records.  Where  the  cash  items  are  not 
listed  at  the  opening  of  the  mail,  there  is  practically  no  internal 
check  on  cash  receipts,  since  it  is  impossible  for  the  person  opening 
the  mail  to  remember  the  nature  or  amount  of  all  or  even  a  large 
part  of  the  items  received.  Furthermore,  even  if  it  were  possible, 
it  would  not  be  an  efficient  check.  If  any  independent  control 
at  all  is  to  be  exercised,  the  cash  items  must  be  Hsted  at  once  and 
the  hst  must  subsequently  be  compared  with  the  cash  records. 

Cash. — All  money  received,  whether  in  the  form  of  cheques  or 
cash,  should  be  deposited  in  the  bank  daily. 

All  cash  payments  should  be  made  by  cheque  signed  by  one 
of  the  principals  and  supported  by  a  duly  authorized  voucher. 
Small  payments  that  must  be  made  in  currency  should  be  made 
from  a  petty  cash  fund  set  aside  for  that  purpose. 

Receipts  or  vouchers  should  be  secured  for  all  disbursements 
from  this  petty  cash  fund,  and  at  frequent  intervals  the  cashier 
should  prepare  a  statement  of  disbursements  made  therefrom. 
Upon  surrender  of  this  statement  accompanied  by  the  vouchers 
or  receipts,  certified  to  by  the  cashier  as  to  correctness  of  the 
items,  he  should  be  reimbursed  by  cheque  for  the  total  amount 
shown  by  the  statement.  This  should  also  be  done  at  the  close  of 
each  fiscal  period. 

The  cashier  should  not  have  access  to  any  of  the  individual 
ledgers,  nor  to  statements  sent  to  customers. 

The  bank  balance  should  be  reconciled  monthly  by  the  book- 
keeper or  someone  other  than  the  cashier,  if  possible.  The  out- 
standing cheques  should  be  listed,  and  the  balance  shown  to  be 
in  bank  should  be  reconciled  with  the  balance  called  for  by  the 


64  AUDITING— GENERAL  PRINCIPLES 

cash  book.  The  payments  covered  by  cheques  of  large  amount 
which  are  listed  as  outstanding  for  more  than  thirty  days  should 
be  investigated. 

Invoices  for  Purchases. — The  issuing  of  orders  for  the 
purchase  of  goods  or  materials  is  one  of  the  most  important  duties 
to  be  performed  in  any  organization.  While  in  smaller  concerns 
this  work  is  frequently  performed  by  a  principal,  in  larger  enter- 
prises it  is  usually  necessary  to  delegate  the  work  to  an  employee. 

One  person  should  be  responsible  for  all  purchases.  Requisi- 
tions for  requirements  of  the  various  departments  should  be  sent 
to  him  and  formal  orders  should  be  issued  from  his  department,  or 
else  all  orders  issued  should  be  subject  to  his  approval. 

Every  purchase  requisition  should  bear  a  number,  be  properly 
dated,  and  should  have  a  notation  indicating  the  department  in 
which  it  originated.  As  a  general  rule  orders  should  state  prices 
and  exact  quantities  required. 

Purchase  orders  should  contain  instructions  and  conditions 
which  will  facihtate  the  delivery  of  the  goods  and  the  preparation 
of  correct  invoices  as  well  as  protect  the  client  in  case  of  contro- 
versies relative  to  prices,  deliveries,  etc.  The  purchase  depart- 
ment should  have  sufficient  data  relative  to  quotations,  prices, 
etc.,  to  enable  the  client  to  determine  whether  purchases  are  being 
made  at  the  best  possible  prices. 

The  question  of  transportation  charges  or  allowances  should 
be  investigated  and  a  special  notation  made  in  those  cases  where 
the  freight  charge  or  allowance  is  to  be  charged  to  the  shipper. 

Duplicate  copies  of  all  orders  should  be  retained,  and  one  of 
these  copies  should  have  a  suitable  blank  space  for  entering  the 
date  and  amoimt  of  invoices  received  applying  against  that  order, 
thus  making  it  more  difficult  to  pass  a  duplicate  invoice. 

A  careful  record  should  be  made  of  all  goods  received.  In 
some  of  the  larger  concerns  copies  of  orders  from  which  the  quan- 
tities and  prices  have  been  eliminated  are  sent  to  the  receiving 
clerk  for  his  information.    Then  upon  receipt  of  the  goods  or 


AUDIT  PROCEDURE  65 

materials  the  receiving  clerk  enters  the  quantities  and  sends  the 
copy  of  the  order  to  the  accounting  department  to  be  compared 
with  the  invoices.  For  purposes  of  internal  check  or  even  for 
auditing  purposes  the  receiving  record  is  of  Kttle  value  unless 
it  contains  in  detail  the  quantity  and  the  description  of  every 
item. 

In  some  concerns,  notably  department  stores,  purchase  in- 
voices are  registered  before  being  sent  to  the  receiving  room  or  to 
the  various  buyers.  After  an  invoice  has  been  passed  by  a  buyer 
it  is  returned  to  the  registry  office,  checked  off  in  the  register,  and 
sent  to  the  accounts  payable  division  for  entry  in  the  purchase 
record.  The  invoice  register  is  used  as  a  means  of  keeping  track 
of  invoices,  and  it  also  has  a  further  use  in  connection  with  the 
determination  of  the  HabiHty  for  merchandise  in  transit  or  mer- 
chandise held  in  the  receiving  room,  as  the  open  items  on  the 
register  should  represent  the  total  of  merchandise  still  held  in 
the  receiving  room,  not  officially  received,  plus  merchandise  en 
route. 

If  the  receiving  clerk  is  not  competent  to  pass  upon  the  qual- 
ity, he  should  ask  for  the  assistance  of  someone  who  is  competent 
from  one  of  the  other  departments.  The  operation  of  comparing 
the  invoice  with  the  order,  the  checking  of  quantities,  quahty, 
prices,  and  extensions  should  be  indicated  by  the  initials  of  those 
responsible  for  each  operation,  respectively. 

Before  being  sent  to  the  treasurer  for  payment,  invoices  should 
be  approved  by  the  executive  in  charge  of  the  accounting  depart- 
ment; and  when  the  cheque  is  drawn  this  fact  should  be  noted 
on  the  invoice  in  some  manner,  to  avoid  a  second  payment.  If 
the  voucher  system  of  payment  is  not  used,  the  stub  of  the  cheque 
should  show  sufficient  information  to  enable  the  bookkeeper  to 
identify  the  items  paid.  The  accounts  payable  accounts  or  credi- 
tors ledger  accounts  should  be  balanced  at  regular  intervals. 
The  shipping  clerk  should  keep  a  separate  record  of  purchases 
returned,  and  this  record  should  be  systematically  followed  up  to 
secure  credit  from  the  original  shippers. 


66  AUDITING— GENERAL  PRINCIPLES 

Sales  Invoices. — A  systematic  record  should  be  made  of  all 
orders  received.  When  shipments  are  made  shipping  orders 
should  be  compared  with,  and  notations  made  on,  the  sales  orders 
to  that  effect.  Invoices  should  then  be  prepared  from  these  sales 
orders. 

The  quantities,  prices,  extensions,  and  additions  of  all  sales 
invoices  should  be  checked  at  least  once  before  the  invoices  are 
sent  out.  This  checking  should  include  a  comparison  with  the 
customer's  order  or  an  abstract  thereof. 

Whenever  possible,  the  duphcate  copy  method  of  writing  the 
sales  book  should  be  used,  the  first  carbon  copy  of  the  invoice 
becoming  the  sales  record.  This  suppHes  in  the  sales  book  an 
exact  copy  of  the  invoice  sent  out  and  is  admissible  as  evidence 
in  court. 

The  receiving  clerk  should  keep  a  separate  record  of  sales  re- 
turned, which  record,  subject  to  the  approval  of  somebody  in 
authority,  should  be  the  basis  for  rendering  credits  for  such  goods 
to  customers. 

Customers'  Accounts. — As  stated  previously,  the  employee 
in  charge  of  cash  receipts  should  not  have  access  to  customers 
ledgers. 

Allowances  should  not  be  made,  except  upon  written  approval 
from  proper  authority;  and  journal  entries  to  close  out  accounts, 
such  as  bad  accounts,  should  be  supported  by  official  authorization. 

If  customers'  accounts  are  kept  in  subsidiary  ledgers,  the 
subsidiary  records  should  be  balanced  with  the  controlling  ac- 
count at  regular  intervals. 

Collections. — Some  systematic  method  should  be  followed 
in  the  collection  of  accounts.  In  larger  concerns  this  should  be  in 
the  hands  of  a  separate  department.  In  any  case  it  should  not  be 
left  entirely  in  the  hands  of  the  bookkeeper. 

Pay-Rolls.— The  method  of  preparing  the  pay-rolls  should 
be  such  that  every  step  receives  an  independent  check  by  some- 


AUDIT  PROCEDURE  67 

body  other  than  those  in  direct  charge  of  the  work.  A  record 
should  be  kept  of  the  name  and  rate  of  each  employee,  and  no 
entries  should  be  made  on  this  record,  either  in  the  way  of  addi- 
tions or  changes,  without  proper  authority  in  writing.  In  larger 
establishments  a  separate  employment  department  should  be 
maintained.  The  pay-roll  record  should  be  compared  with  the 
emplo3anent  department  records  as  to  name,  date,  when  em- 
ployee entered  and  left  the  service  and  rates  of  pay.  Payments  of 
money  to  employees  should  be  made  in  the  presence  of  two  or 
more  persons,  and  both  the  paymaster  and  the  witness  should 
sign  the  pay-roll  sheets  to  evidence  the  payment.  A  list  should 
be  made  of  all  pay  envelopes  left  over,  which  record  should  be 
handed  to  the  accounting  department  as  soon  as  it  is  completed. 
The  accounting  department  should  inspect  all  receipts  for 
amounts  subsequently  paid,  and  verify  the  entry  made  for  the 
balance  of  the  envelopes  not  called  for. 

Stock  Records. — Where  practicable,  a  perpetual  inventory 
of  stock  on  hand  should  be  maintained.  The  quantities  shown  by 
this  inventory  should  be  verified  from  time  to  time  by  comparison 
with  the  actual  goods  or  materials.  An  entry  should  be  made  of 
all  material  purchased  or  manufactured  as  received  in  the  store- 
room, as  evidenced  by  a  receiving  report.  No  material  should  be 
issued  without  a  requisition,  which  in  due  course  is  entered  in  the 
stock  records. 

Vacations. — Every  member  of  the  office  staff  should  be  re- 
quired to  take  a  vacation  at  least  once  a  year.  It  is  advisable  to 
transfer  employees  from  one  position  to  another  at  more  or  less 
frequent  intervals,  depending  upon  the  class  of  work  which  they 
perform. 

Branch  Office  Accounts 

Where  branch  offices  are  purely  sales  offices,  it  is  customary 
to  pay  the  petty  expenses  of  the  office  from  a  petty  cash  fund 
advanced  to  the  branch.    Reports  of  petty  disbursements  accom- 


68  AUDITING— GENERAL  PRINCIPLES 

panied  by  vouchers  are  sent  to  the  home  office  periodically,  and  a 
cheque  is  then  drawn  to  reimburse  the  branch  petty  cash  fund. 
The  auditor  should  examine  these  reports  and  the  vouchers  ac- 
companying them.  The  reports  should  show  the  approval  of  the 
person  in  charge  of  the  branch  office,  and  in  some  cases  it  is  desir- 
able that  each  voucher  should  show  the  proper  approval.  Cases 
are  known  where  the  amounts  of  express  bills  have  been  raised  by 
office  boys  before  the  bills  were  presented  to  the  local  cashier  for 
payment.  The  auditor  should,  of  course,  examine  very  closely 
any  bills  which  show  indications  of  erasures,  and  make  a  further 
investigation  if  the  facts  warrant. 

If  invoices  are  rendered  and  customers'  accounts  kept  at  the 
branch  office,  it  may  be  that  a  complete  system  of  internal  check 
will  make  it  unnecessary  for  the  auditor  to  visit  the  branch  office, 
although  such  cases  are  rare. 

Some  companies,  due  largely  to  the  nature  of  their  business, 
have  an  almost  infallible  check  on  their  branches.  A  perpetual 
inventory  of  all  goods  shipped  to  or  purchased  by  the  branch  is 
kept  at  the  home  office.  Copies  of  all  bills  rendered  by  the  branch 
are  sent  to  the  home  office,  where  either  a  controlling  account  of 
the  branch  customers  ledger  or  a  duplicate  set  of  customers' 
accounts  is  kept.  A  trial  balance  of  the  branch  ledgers  is  sent  to 
the  home  office  at  the  end  of  each  month;  copies  of  all  credits 
rendered  and  journal  entries  made  are  also  sent  to  the  home  office, 
where  they  are  carefully  inspected  before  being  approved.  Cash 
collections  are  deposited  in  a  local  bank  account,  over  which  the 
branch  has  no  control,  cheques  on  this  account  being  drawn  at  the 
home  office.  By  the  use  of  carbon  paper,  copies  are  made  of  the 
branch  office  cash  book  and  one  of  these  copies  is  sent  to  the  home 
office  each  day,  accompanied  by  signed  dupHcate  deposit  slips. 
Statements  and  paid  cheques  are  sent  direct  to  the  home  office  by 
the  local  bank.  Disbursements  for  petty  expenses  at  the  branch 
are  made  from  a  petty  cash  fund  such  as  has  been  previously 
described.  The  auditor's  duty  in  cases  of  this  kind  should  be  to 
see  that  the  system  as  planned  is  carefully  carried  out  at  the  home 


AUDIT  PROCEDURE  69 

office,  and  he  should  make  such  tests  as  may  be  necessary  to 
satisfy  himself  that  this  is  being  done. 

Assets  at  Branches,  etc.,  Paid  eor  in  Foreign  Cur- 
rency.— Fixed  Assets.  At  the  time  when  acquired,  all  fixed  assets 
paid  for  in  foreign  currency  should  be  set  up  on  the  home  office 
books  in  United  States  currency,  whether  paid  for  out  of  specific 
remittances  or  out  of  the  general  funds  of  the  foreign  branch. 
The  reason  for  this  is  that  the  book  cost  is  not  affected  by  subse- 
quent fluctuations  in  exchange ;  obviously,  if  the  book  cost  is  not 
set  up  in  dollars  at  the  time  of  acquisition,  subsequent  valuations 
will  reflect  temporary  fluctuations  and  unnecessarily  and  im- 
properly obscure  actual  costs.  Depreciation,  depletion,  and 
amortization  should  all  be  computed  on  the  basis  of  original  cost 
in  dollars  irrespective  of  subsequent  fluctuations  in  the  value  of 
the  foreign  currency. 

Current  Assets.  The  net  current  assets  at  the  date  of  closing 
the  books  should  be  converted  into  dollars  at  the  prevailing  rate 
of  exchange  on  that  date.  ^  It  therefore  is  unnecessary  to  attempt 
to  identify  the  disposition  of  the  remittances  during  the  period  so 
far  as  current  assets  are  concerned.  When  the  charges  against 
the  branches  are  for  materials  and  supplies,  authorities  differ  as 
to  the  proper  treatment.    The  following  bears  on  this  point. 


'  "  At  the  close  of  the  fiscal  period,  when  the  books  are  closed,  no  change  is 
made  in  the  debit  balances  of  the  fixed-asset  accounts  because  of  the  estab- 
lished principle  that  fixed  assets  should  be  valued  at  cost,  regardless  of  market 
fluctuations.  In  regard  to  the  floating  assets  and  liabilities,  the  custom  is  to 
convert  the  values  at  the  rate  of  exchange  current  on  the  day  of  closing.  There 
is  considerable  variation  in  the  procedure  for  the  valuation  of  nominal  account 
balances — sometimes  they  are  converted  at  an  average  rate  for  the  period,  and 
sometimes  at  the  current  rate  at  the  end  of  the  period.  While  the  average-rate 
method  is  usually  advocated  on  the  ground  that  the  earnings  and  expenses 
accrued  during  the  period,  this  method  is  subject  to  the  objection  that  a  simple 
average  of  the  rates  of  all  days  during  the  period  fails  to  take  into  consideration 
the  fact  that  transactions  varied  in  volume  from  day  to  day.  As  the  operations 
resulted  in  an  increase  or  decrease  of  the  net  current  assets  at  the  branch  and 
since  these  current  assets  and  current  liabilities  are  converted  at  the  rate  cur- 
rent at  the  end  of  the  period,  it  would  seem  consistent  to  convert  the  current- 
account  balances  at  the  same  rate."  (H.  A.  Finney,  Journal  of  Accountancy, 
June,  192 1,  Vol.  xxxi,  page  458.) 


70  AUDITING— GENERAL  PRINCIPLES 

If  the  home  office  buys  for  gold  and  ships  to  the  plant  any  raw  materials 
or  supplies  that  are  not  immediately  used,  it  should  charge  and  the  plant 
should  credit  the  silver  value  at  the  rate  of  exchange  at  the  time  of  ship- 
ment. As  the  articles  are  used,  it  would  seem  the  proper  procedure  to 
charge  them  to  operating  costs  at  the  same  rate.  However,  Sir  A.  Lowes 
Dickinson  says,  "The  most  satisfactory  method  of  dealing  with  this  con- 
dition is  to  keep  the  accounts  of  materials,  stores  and  supplies  originating 
in  the  United  States  in  United  States  currency  until  they  are  used,  and 
then  to  charge  them  out  to  the  accounts  concerned — whether  construction 
or  operating — at  the  rate  of  exchange  current  on  the  date  of  issue  for  con- 
sumption; in  other  words,  these  materials,  etc.,  while  in  fact  in  China,  are 
deemed  to  be  in  the  United  States  until  issued  for  consumption,  and  are 
only  then  passed  through  the  current  accounts  between  the  two  offices." 

This  is  open  to  the  objection  that  the  accounts  at  the  plant  will  not 
reflect  the  true  conditions,  as  the  plant  may  be  in  possession  of  a  large 
amount  of  materials,  etc.,  which  will  not  appear  on  its  books  until  used, 
and  to  the  further  objection  that,  if  the  materials  are  issued  very  fre- 
quently, the  rate  at  which  they  must  be  charged  to  operations  by  the 
branch  manager  will  be  subject  to  constant  variation  with  regard  to  actual 
cost,  and  that  no  silver  value  can  be  expressed  on  the  home-office  books  un- 
til the  report  of  the  dates  and  quantities,  of  the  different  issues  is  received 
in  the  United  States.^ 

Without  attempting  to  discuss  fully  this  point,  the  author  is 
of  the  opinion  that  all  materials,  supplies,  etc.,  actually  on  hand 
at  foreign  branches  should  be  converted  into  foreign  values  when 
received  at  such  points.  When  inventoried  the  same  basis  should 
be  used,  whether  the  goods  were  purchased  locally  or  shipped  by 
the  home  office.  To  sum  up:  The  values  of  goods  and  other 
current  assets  are  immediately  converted  into  foreign  currency 
at  the  branches  in  order  to  be  on  the  same  basis  as  local  purchases; 
at  inventory  time  foreign  currency  is  used  at  the  branches;  at  the 
home  ofhce  the  conversion  of  all  current  asset  accounts  and  ad- 
vances into  domestic  currency  will  result  in  the  inventories  being 
valued  on  the  same  basis  at  the  end  of  the  period,  and  at  the  same 
time  will  absorb  all  profits  or  losses  on  exchange  during  the  year. 


3  H.  A.  Finney,  Journal  of  Accountancy,  June,  192 1,  Vol.  xxxi,  page  458. 


CHAPTER  VI 
BALANCE  SHEET  AUDIT— ASSETS 

In  this  chapter  will  be  discussed  the  general  principles  which 
underlie  the  audit  of  all  assets  which  appear  or  which  should 
appear  on  the  balance  sheet. 

The  requirements  of  credit  grantors  compel  correct  grouping 
or  classification;  terms  are  explained,  defined,  and  discussed. 
The  audit  of  current  assets  will  next  be  outlined,  following  the 
order  in  which  the  assets  appear  in  the  best  form  of  balance  sheet. 

General  Principles 

The  imderlyingfprinciples  of  a  balance  sheet  audit  may  be 
reduced  to  writing.  They  are  not  subject  to  change  to  fit  particu- 
lar businesses  or  special  systems  of  account.  They  are  few  in 
number  and  can  be  applied  generally.    They  are  as  follows : 

The  auditor  must  ascertain — 

1.  That  all  of  the  assets  shown  by  the  books  as  having  been 

on  hand  at  a  certain  date  were  actually  on  hand. 

2.  Whether  any  other  assets,  not  on  the  books,  should  have 

been  on  hand. 

3.  That  the  habilities  shown  by  the  books  as  owing  at  a 

certain  date  were  actual  liabilities. 

4.  Whether  or  not  all  habiUties  were  in  fact  shown  by  the 

books. 

5.  Whether  or  not  the  liabilities  so  shown  were  properly 

incurred. 

6.  That  the  surplus  and  the  income  accounts  are  properly 

stated. 

In  the  following  pages  these  theories  are  discussed  and  the 
work  incident  to  a  balance  sheet  audit  is  explained. 

71 


^2  AUDITING— GENERAL  PRINCIPLES 

In  Appendix  A  will  be  found  the  complete  text  of  a  tentative 
proposal  for  uniform  accounting  submitted  in  191 7  by  the  Fed- 
eral Reserve  Board  ''for  the  consideration  of  banks,  bankers  and 
banking  associations;  merchants,  manufacturers  and  associations 
of  manufacturers;  auditors,  accountants  and  associations  of 
accountants."  It  gives  an  outline  of  the  work  to  be  done  and  the 
statements  to  be  submitted  in  connection  with  a  balance  sheet 
audit.  It  was  prepared  primarily  to  assist  bankers.  It  is  assumed 
that  accountants  will  submit  balance  sheets  as  nearly  uniform  in 
their  arrangement  as  possible.  In  addition,  it  is  the  aim  of  the 
Federal  Reserve  Board  that  balance  sheet  audits  shall  be  per- 
formed in  such  a  manner  that  the  banker  can  rely  reasonably 
on  the  accuracy  of  the  various  items  appearing  in  the  balance 
sheet. 

The  proposal  states  that  the  scope  of  a  balance  sheet  audit  of 
an  industrial  or  mercantile  corporation  or  firm  comprises  a  veri- 
fication of  the  assets  and  liabiHties,  a  general  examination  of  the 
income  account,  and,  incidental  thereto,  an  examination  of  the 
essential  features  of  the  accounts. 

Limitations  of  Balance  Sheet  Audits  Must  Be  Understood 

In  arranging  for  a  balance  sheet  audit,  the  distinction  between 
an  audit  of  that  character  and  a  detailed  audit  should  be  pointed 
out  to  the  client. 

Sometimes  after  a  balance  sheet  audit,  which  was  specified  in 
writing,  is  made  and  the  report  rendered,  it  is  discovered  that 
petty  defalcations  have  been  going  on  for  a  long  time.  It  is 
natural  for  the  client,  in  such  case,  to  criticize  the  auditor;  but  if 
the  latter  has  a  written  order  to  which  he  can  refer,  he  can  clearly 
show  that  the  detection  of  the  small  theft  was  not  within  the 
scope  of  the  audit.  If,  however,  the  auditor  is  careless  about  the 
preliminary  arrangements  and  neither  explains  orally,  nor  puts  in 
writing,  the  limitations  of  a  balance  sheet  audit,  he  will  find  him- 
self in  an  embarrassing  position  and  will  be  fortunate  if  the 
worst  that  happens  is  the  loss  of  the  client. 


BALANCE  SHEET  AUDIT— ASSETS  73 

Although  an  auditor  cannot  be  held  liable  in  money  damages 
unless  negligence  is  proved,  yet  a  jury  may  find  that  a  client  who 
instructed  a  professional  auditor  to  ''make  an  audit,"  without  any 
limitations  being  mentioned,  can  reasonably  expect  the  details 
of  his  accounts  to  be  fully  covered.  For  instance,  an  auditor 
when  making  a  balance  sheet  audit  rarely  proves  the  footings  of 
the  petty  cash  book;  but  if  it  is  afterwards  found  that  these 
footings  have  been  systematically  overstated  and  the  client  de- 
frauded, an  auditor's  freedom  from  or  liability  for,  negligence  may 
rest  entirely  on  the  conditions  of  his  employment. 

Analysis  of  Assets 

One  important  point  to  be  kept  in  mind  in  a  balance  sheet 
audit  is  that  an  entry  on  the  books  which  purports  to  record  an 
asset  is  nothing  more  than  a  book  record,  and  that  there  can 
be  no  good  excuse  for  accepting  such  entry  as  final.  The  data 
supporting  the  entry  may  be  in  order,  but  it  is  the  auditor's 
duty  to  verify  independently,  as  far  as  possible,  the  fact  that 
the  asset  still  exists,  or  did  exist  at  the  date  of  the  balance 
sheet. 

Assets  are  divided  into  current,  fixed,  and  miscellaneous.  It 
is  possible  to  classify  most  asset  items  as  current  or  fixed,  but 
there  are  accounts,  such  as  discount  on  bonds  and  certain  claims, 
which  are  usually  stated  separately. 

Tangible  and  Intangible  Assets. — In  addition  to  the  se- 
gregation of  assets  into  current  and  fixed,  another  classification 
is  often  used,  viz.,  tangible  and  intangible.  These  terms  are  de- 
fined on  page  174. 

Working  Assets. — The  term  "working  assets"  is  sometimes 
used  synonymously  with  "current  assets,"  and  in  other  cases  an 
attempt  is  made  to  differentiate  between  "working"  and  "cur- 
rent." In  the  author's  opinion  the  word  "working"  might  be 
used  to  describe  plant  as  well  as  current  assets.  In  any  event  it 
is  not  a  good  term  and  its  use  should  be  abandoned. 


74  AUDITING— GENERAL  PRINCIPLES 

Basis  of  Valuation  of  Assets 

As  a  rule  fixed  assets  are  'Valued"  at  cost  less  depreciation. 
In  some  cases  appraisal  values  are  substituted  for  cost.  From  the 
standpoint  of  actual  value,  for  some  special  purposes  an  appraisal 
is  desirable;  from  the  standpoint  of  a  going  business  it  is  better 
to  ignore  fluctuations  in  values. 

Current  assets  usually  are  not  all  valued  on  the  same  basis. 
Cash,  accoimts  and  notes  receivable,  and  prepaid  items  are 
stated  at  realizable  values.  Inventories  are  usually  valued  at  so- 
called  market  prices  if  the  market  is  lower  than  cost,  and  thus  all 
of  the  current  assets  are  valued  on  the  same  basis;  if  so-called 
costs  are  lower  than  so-called  market  prices,  the  market  basis  is 
ignored  and  thus  the  current  assets  are  valued  on  different  bases. 

The  valuations  of  fixed  and  current  assets  are  discussed  in 
detail  in  this  and  succeeding  chapters.  At  this  point  it  is  only 
necessary  to  mention  that  accounting  practice  does  not  always 
call  for  balance  sheet  valuations  either  on  a  basis  of  what  the 
assets  are  worth  as  a  going  business  or  what  they  are  worth  in 
hquidation.  It  is  an  interesting  study  to  attempt  to  establish 
uniform  rules  which  will  govern  balance  sheet  construction  and 
enable  the  users  of  balance  sheets  to  determine  the  true  net  worth 
of  the  concern  under  audit. 

Definition  of  Market  Value. — Even  though  market  val- 
ues frequently  have  been  ignored  in  balance  sheets,  the  time  is 
coming  when  more  attention  will  be  paid  to  true  values.  ^    ''  Mar- 


^  "Value.  (A)  This  term  has  two  different  meanings.  It  sometimes  ex- 
presses the  utility  of  an  object,  and  sometimes  the  power  of  purchasing  other 
goods  with  it.  The  first  may  be  called  the  value  in  use,  the  latter  the  value  in 
exchange. 

"  (B)  In  the  first  sense,  the  term  has  been  defined  as  the  price  deemed  or 
accepted  as  equivalent  to  the  utility  of  anything ;  the  utility  of  an  object ;  worth. 

"  (C)  In  the  second  sense,  the  term  has  been  defined  as  the  sum  for  which 
the  like  goods  are  commonly  bought  and  sold  in  the  market;  the  sum  of  money 
a  thing  produces  to  the  seller  when  it  is  sold;  the  amount  of  other  commodities 
(commonly  represented  by  money)  for  which  a  thing  can  be  exchanged  in  open 
market;  the  worth  of  an  object  in  purchasing  other  goods;  the  exchange  power 
which  one  commodity  or  service  has  in  relation  to  another;  price  or  the  amount 
for  which  a  thing  can  be  sold."     (39  Cyc.  1 1 1?-) 


BALANCE  SHEET  AUDIT— ASSETS  75 

ket  value"  is  the  price  at  which  a  seller  willing  to  sell  at  a  fair 
price  and  a  buyer  willing  to  buy  at  a  fair  price,  both  having 
reasonable  knowledge  of  the  facts,  will  trade. 

Current  Assets 

The  current  assets  are  called  "quick,"  or  "floating,"  or  "li- 
quid," or  "working."  The  author  prefers  the  term  "current"  for 
those  assets  which  represent  cash  or  items  which  will  or  should  be 
converted  into  cash  during  the  current  operations  of  the  business. 

Definition  of  Term  "Current  Assets." — The  agreements 
imder  which  many  issues  of  preferred  stock,  notes,  bonds,  and 
other  obligations  have  been  placed,  contain  stipulations  as  to  the 
percentage  ratio  of  current  or  quick  ^  assets  to  current  habilities, 
or  the  reference  is  to  "net  current  assets."  The  absence  of  uni- 
form practice  is  recognized  in  most  cases  by  the  enumeration  of 
the  specific  items  which  comprise  the  assets  and  liabilities  which 
are  to  be  included.  The  main  purpose  of  the  provisions  is  to 
prevent  any  undue  expansion,  particularly  of  fixed  assets.  It  is 
believed  that  good  accounting  practice  is  well  enough  settled  to 
justify  definitions  which  will  control  the  classification  on  any 
balance  sheet  and  do  away  with  the  necessity  for  specifying  the 
items  to  be  included.  In  some  agreements  deferred  assets  are 
excluded  from  the  definition;  in  many  carefully  worded  agree- 
ments prepaid  items  are  specifically  included.  A  definition  or 
classification  which  excludes  all  deferred  assets  may  work  an 
unintentional  hardship.  Considerable  savings  are  made  by  pre- 
paying interest,  insurance,  and  similar  items,  therefore  no  defini- 
tion should  be  so  inelastic  as  to  place  a  premium  on  the  absence  of 
deferred  asset  items  irrespective  of  the  merits  of  the  case.  It 
might  be  possible  to  invent  ledger  captions  which  would  help 


^  As  the  words  "quick"  and  "current"  are  synonymous  and  the  latter 
is  in  rtiore  general  use,  it  will  be  used  exclusively.  In  bankers'  circulars  the 
words  are  used  interchangeably  in  referring  to  the  same  items.  In  the  balance 
sheet  of  one  well-known  concern  the  words  "current,"  "quick,"  and  "working" 
are  used  interchangeably. 


76  AUDITING— GENERAL  PRINCIPLES 

evade  specific  provisions,  whereas  if  the  intention  is  clear  and  the 
definition  is  elastic  there  can  be  no  evasion. 

Settling  first  the  matter  of  intention,  there  is  little  controversy- 
regarding  the  meaning  of  the  term  ''current  assets."  Speaking 
generally,  the  term  includes  only  those  assets  which  are  for  sale 
in  the  ordinary  course  of  business.  If  any  doubt  exists,  it  can  be 
settled  by  the  answer  to  the  question:  *'Is  it  desirable  or  is  it  the 
purpose  of  the  business  to  convert  these  assets  into  cash  at  the 
earliest  practicable  moment?"  This  is  not  an  entirely  satisfac- 
tory definition  because  it  permits  the  inclusion  of  ''slow"  assets 
and  others  which  could  not  be  dispensed  with  unless  the  business 
were  to  liquidate;  it  lays  down  no  rule  for  valuing  inventories; 
it  omits  prepaid  expenses.  As  the  intention  is  clear,  the  definition 
also  can  be  clear.  The  intention  when  related  to  a  going  business 
is  to  include  all  items  of  a  "cash"  or  realizable  nature  as  distin- 
guished from  fixed  or  unrealizable  assets.  If  we  discuss  what  must 
be  excluded,  we  will  better  understand  what  to  include. 

Classification  of  Assets. — The  asset  side  of  a  balance  sheet 
should  be  divided  into  four  main  groups:^     (i)  current,  (2)  fixed 
tangible,  (3)  fixed  intangible,  (4)  miscellaneous.    These  are  fur- 
ther divided  as  follows: 
I .  Current  Assets : 

(a)  Cash  (cash  "items,"  if  any,  must  be  distributed 

under  some  other  caption). 

(b)  Items  the  equivalent  of  cash,  such  as  postage, 

revenue  and  war  savings  stamps. 

(c)  Accounts,  notes  receivable,  and  acceptances  from 

trade  debtors,  net  of  reserves  for  bad  and  doubt- 
ful accounts,  the  maturities  of  which  are  less 
than  one  year  from  the  date  of  the  balance 
sheet. 


3  These  captions  are  not  in  general  use;  many  agreements,  however,  are 
being  made  under  which  it  is  compulsory  to  segregate  the  assets  into  the 
specific  groups  mentioned. 


BALANCE  SHEET  AUDIT— ASSETS  77 

(d)  Instalment  or  deferred  accounts  and  notes  receiv- 

able, even  though  maturing  more  than  one  year 
from  the  date  of  the  balance  sheet,  provided  that 
such  accounts  or  notes  were  accepted  in  ordinary 
course  and  conform  to  the  terms  which  generally 
prevail  in  that  line  of  business. 

(e)  Inventories  of  raw  materials  and  finished  goods, 

operating  suppHes,  goods  in  process,  and  ordinary 
maintenance  material  and  parts. 

(f)  Accounts  and  notes  receivable  from  stockholders, 

employees,  and  others  when  separately  stated  on 
the  balance  sheet  and  known  to  be  collectible 
within  less  than  one  year. 

(g)  Advances  on  contracts;  prepaid  expenses,  such  as 

interest  on  bank  loans;  prepaid  royalties,  insur- 
ance, and  taxes;  and  all  other  items,  such  as  cur- 
rent advertising,  catalogs,  and  booklets,  which 
directly  relate,  as  does  the  inventory,  to  cur- 
rent operations  and  which  when  and  as  used 
are  operating  costs.  This  class  is  limited  to 
those  items  which  would  be  paid  in  any  event 
after  the  date  of  the  balance  sheet  and  which 
are  not  indicative  of  any  expansion  of  the  busi- 
ness, 
(h)  Securities  and  other  items  which  are  the  equivalent 
of  cash  and  which  are  intended  to  be  or  which 
readily  may  be  converted  into  cash. 
Fixed  Tangible  Assets: 

(a)  Plant,   including  land,   mines,   other  natural  re- 

sources and  development  costs,  machinery, 
equipment,  automobiles,  furniture,  tools,  con- 
tainers, and  patterns. 

(b)  Inventories  of  plant  items,  such  as  construction 

and  renewal  materials  and  parts  other  than  for 
maintenance. 


78  AUDITING— GENERAL  PRINCIPLES 

(c)  Items  the  same  as  (c)  and  (f)  above,  the  benefits 

or  maturities  of  which  are  more  than  one  year 
from  the  date  of  the  balance  sheet. 

(d)  Deposits,  prepaid  items,  etc.,  the  benefit  of  which 

extend  beyond  one  year  from  the  date  of  the 
balance  sheet. 

(e)  Securities  of  subsidiary  or  affihated  concerns.    (If 

a  consolidated  balance  sheet  is  not  made  up,  ad- 
vances to,  and  accounts  receivable  from,  such 
concerns  should  be  included  in  this  group.) 

(f)  Fund  investments  when  the  assets  in  the  funds  are 

to  be  applied  to  the  reduction  of  debts  or  for 
reinvestment  for  the  purposes  of  the  concern. 

(g)  Patents  when  acquired  for  cash. 

3.  Fixed  Intangible  Assets: 

(a)  Patents,    trade-marks,     copyrights,    subscription 

fists,  etc. 

(b)  Good-wiU. 

(c)  Deferred  items,  such  as  discount  on  bonds,  and 

deferred  items  of  an  extraordinary  nature,  such 
as  organization  and  exploitation  expenses. 

4.  Miscellaneous  Assets : 

(a)  Fiduciary  and  other  items,  such  as  claims  and 

disputed  items  which  cannot  be  included  in  the 
foregoing  classifications. 

(b)  Discount  on  bonds. 

If  the  audit  occurs  some  time  after  the  closing  date,  numerous 
entries  and  changes  are  apt  to  have  been  made  in  the  current 
assets  subsequent  to  the  date  of  closing.  These  must  be  carefully 
scrutinized  for  the  fight  they  may  shed  on  the  past. 

At  the  outset  the  auditor  should  carefully  read  the  schedule 
of  assets  to  be  verified  and  then  outline  a  definite  plan  having  as 
its  basis  the  connection  between  the  entries  supporting  the  asset 
accounts  and  the  things  themselves.    In  other  words,  all  of  the 


BALANCE  SHEET  AUDIT— ASSETS  79 

assets  which  should  he  on  hand  must  be  accounted  for,  including 
both  those  on  the  books  and  those  which  may  have  been  omitted 
from  the  books. 

Net  Current  Assets. — The  term  ''net  current  assets"  is 
sometimes  used  in  deeds  of  trust  and  other  agreements  for  the 
protection  of  creditors.  The  term  ''  current  assets"  is  defined  on 
page  75.  The  term  ''current  liabilities"  is  defined  on  page  223. 
The  term  "net  current  assets"  means  the  excess  of  current  assets 
as  defined  over  current  liabilities  as  defined. 

Liens  and  Hypothecations. — Throughout  the  verification  of 
the  current  assets  the  auditor  should  be  vigilant  in  his  endeavor 
to  ascertain  whether  the  title  to  the  accounts — the  stock-in-trade, 
the  machinery,  and  other  items — is  free  and  clear,  or  whether 
a  Hen  exists  thereon  which  is  not  fully  disclosed  in  the  books  and 
financial  statements. 

Insurance  policies  are  often  good  guides  to  title.  The  holder 
of  a  lien  on  merchandise  or  the  owner  of  a  chattel  mortgage  is 
usually  careful  to  protect  his  security,  and  wherever  an  insur- 
ance policy  is  payable  to  more  than  one  party  "as  their  interests 
may  appear,"  the  auditor  is  put  on  notice  that  the  property  in- 
sured is  not  free  and  clear. 

A  tremendous  business  is  done  by  companies  which  make  a 
specialty  of  advances  upon,  or  the  purchase  of,  accounts  receiv- 
able. Some  of  these  companies  solicit  business  upon  representa- 
tions that  the  transactions  will  be  secret  and  that  no  information 
relative  thereto  will  be  available  to  the  customers  whose  accounts 
are  assigned,  or  to  the  creditors  whose  interest  in  such  accounts 
receivable  is  thus  subordinated  without  their  knowledge  or  con- 
sent. 

In  many  cases  the  concerns  which  secure  the  advances  greatly 
benefit  therefrom,  being  enabled  to  borrow  in  this  way  enough  to 
finance  their  businesses  properly;  instances  are  known  where  con- 
cerns so  financed  have  thus  escaped  bankruptcy  and  have  sub- 
sequently prospered.    Therefore,  in  general,  an  auditor  should 


80  AUDITING— GENERAL  PRINCIPLES 

not  take  a  definite  stand  for  or  against  the  practice,  but  should 
reserve  his  criticisms  for  abuses  or  objectionable  secrecy. 

The  absolute  necessity  for  disclosing  assignments  is  pointed 
out  on  page  79.  An  effort  may  be  made  to  conceal  from  the 
auditor  the  transfer  of  the  accounts,  but  it  should  not  be  difficult 
to  find  some  trace  of  the  practice ;  and  if  any  accounts  are  trans- 
ferred it  is  a  fair  assumption  (until  clearly  shown  to  the  contrary) 
that  all  have  been  transferred.  The  name  of  a  *' discount"  com- 
pany among  the  liabilities  is,  of  course,  ample  notice  to  the  audi- 
tor; but  the  name  may  be  unfamiliar,  because  there  are  many 
such  companies. 

The  safest  method  is  first  to  determine  which  are  regular  trade 
liabiHties.  After  having  satisfied  himself  of  their  correctness,  they 
may  be  eliminated  from  further  consideration  and  the  auditor 
can  then  devote  his  attention  to  an  investigation  of  the  origin  of 
the  other  items. 

Loans  other  than  from  the  banks  regularly  used  by  the  client 
are  more  likely  than  not  to  be  secured  by  collateral.  The  auditor 
who  examines  the  liabilities  with  this  assumption  in  mind  is  on 
the  safe  side. 

Usually  assignments  of  accounts  receivable  involve  much  red 
tape,  such  as  the  authorization  of  someone  in  the  borrowing 
concern  to  collect  the  accounts  and  to  remit  the  proceeds  to  the 
''discount "  company;  the  preparation  of  schedules  of  accounts  as- 
signed, collected,  etc. ;  and  the  payment  of  bonuses,  commissions, 
interest,  etc.,  at  rates  much  higher  than  the  usual  bank  rate. 
These  precautions  are  more  common  with  the  ''non-notification" 
companies  than  the  others,  because  the  name  implies  secrecy,  and 
care  is  taken  that  customers  shall  not  be  inadvertently  notified 
that  their  accounts  have  been  transferred  as  security  for  loans. 

In  many  cases  the  expenses  incident  to  the  assignment  of 
accounts  receivable  can  be  avoided  and  more  satisfactory  financ- 
ing arranged  for,  as  outlined  under  "Acceptances,"  page  256. 

In  many  instances  goods  are  received  and  so-called  trust  re- 
ceipts are  issued  by  the  consignees.    These  trust  receipts  usually 


I 


BALANCE  SHEET  AUDIT— ASSETS  8l 

arise  out  of  importations  of  raw  materials  shipped  sight  draft 
against  bills  of  lading.  Arrangements  are  made  with  bankers  to 
pay  the  drafts  and  release  the  goods  to  the  purchaser  in  trust,  thus 
creating  a  first  lien  thereon.  In  form  the  trust  receipts  are  obliga- 
tions of  the  purchaser  to  account  to  the  banker  for  the  proceeds 
of  the  sale  of  the  goods. 

The  lien  of  a  trust  receipt  is  frequently  of  temporary  effect 
only,  because  the  goods  are  usually  taken  into  the  purchaser's 
warehouse  and  there  mingled  with  other  goods,  thereby  making 
it  practically  impossible  to  follow  up  and  identify  the  merchan- 
dise. When  the  materials  require  manipulation  and  are  converted 
into  other  forms,  the  difficulties  of  identification  become  almost 
insurmountable.  The  title,  therefore,  which  is  supposed  to  re- 
main in  the  name  of  the  banker,  becomes  of  Httle  value  and  cannot 
be  sustained  against  general  creditors.  There  are,  however,  many 
exceptions  in  which  the  goods  can  be  readily  identified  and  in 
which  the  title  remains  unimpaired. 

In  all  cases  in  which  the  circumstances  surrounding  purchases 
indicate  the  possibihty  of  trust  receipts  having  been  issued,  the 
auditor  must  be  most  vigilant.  The  author's  attention  has  been 
called  to  numerous  cases  in  which  balance  sheets  have  contained 
no  reference  to  existing  liens  of  this  nature.  If  a  concern  con- 
ceals an  important  fact  like  this  from  its  creditors,  there  is  a 
strong  Hkelihood  that  an  attempt  will  be  made  to  deceive  the 
auditor. 

The  head  of  one  concern  which  failed  recently,  when  asked  by 
the  officer  of  a  certain  bank  whether  its  secured  creditors  could 
trace  the  merchandise  on  which  they  had  made  large  advances, 
said  laughingly,  "They  think  they  can."  This  so  disgusted  the 
banker  that  he  immediately  withdrew  a  $100,000  line  of  credit 
from  the  applicant  and  told  him  that  he  could  not  borrow  a  cent 
there. 

Any  information  secured  relative  to  liens  or  encumbrances 
must  be  reflected  in  the  report  on  the  audit,  as  well  as  on  the  face 
of  the  balance  sheet. 


82  AUDITING— GENERAL  PRINCIPLES 

Proportion  of  Current  Assets  to  Other  Liabilities  and 
Capital. — The  rules  call  for  a  verification  of  the  assets  which 
are  on  hand  and  those  which  should  he  on  hand,  but  the  latter 
term  applies  to  physical  existence  only  and  does  not  mean  that 
the  auditor  must  necessarily  pass  upon  the  propriety  of  the  ag- 
gregates of  the  various  classes  of  assets.  At  the  same  time,  in 
order  to  be  as  valuable  as  possible  to  a  client,  whether  a  borrower 
or  a  banker,  the  auditor  should  endeavor  to  determine  whether 
or  not  the  relative  proportions  of  cash,  accounts  receivable,  and 
stock  compare  favorably  with  those  of  the  most  successful  con- 
cerns in  the  same  line  of  business. 

This  thought  is  admirably  expressed  by  the  president  of  one 
of  New  York  City's  largest  national  banks,  who  said  at  a  bankers' 
convention : 

I  have  always  claimed  that  under  normal  business  conditions  a  stated 
amount  of  capital  (borrowed  as  well  as  invested)  should  allow  a  concern 
in  any  line  of  business  to  carry  a  certain  amount  of  merchandise.  This 
merchandise  later  is  converted  into  bills  and  accounts  receivable;  later  on 
into  cash;  and  upon  these  transactions,  subject  to  the  charges  of  conducting 
the  business,  there  should  be  realized  a  certain  amount  of  net  profit.  All 
of  these  items  in  a  well-organized  and  well-conducted  business  should  be  in 
relative  proportion  one  to  the  other.  And  if  the  best  results  are  to  be 
attained,  the  management  of  any  concern  will  see  to  it  that  each  dollar  of 
its  capital  carries  its  proportion  of  merchandise,  and  will  also  see  to  it  that 
the  merchandise  is  moved  rapidly  and  converted  into  a  bill  or  account 
receivable,  and  that  its  outstanding  debts  are  promptly  collected,  and  that 
its  cash  is  used  to  reduce  materially,  or  entirely  liquidate,  its  mdebtedness, 
thereby  saving  interest  and  expense.  We  have  in  a  number  of  instances 
followed  this  natural  sequence  in  business  and  have  found  any  number  of 
instances  where  each  dollar  of  capital  (invested  or  borrowed)  was  not  per- 
forming its  full  duty,  and  following  the  matter  still  further,  we  found  it 
due  to  either  extraordinary  expenses,  or  losses,  or  due  to  indolence  and  a 
lack  of  an  aggressive  policy  in  handling  the  affairs  of  the  concern.  These 
are  **  earmarks"  which  will  denote  a  condition  of  this  kind,  and  we  believe 
that  it  is  our  duty  to  examine  these  conditions  thoroughly. 

As  an  illustration  of  this,  some  years  ago,  a  certain  firm  reported  in 
their  statement  an  invested  capital  almost  equal  to  the  amount  of  their 
annual  sales.     At  the  same  time  their  statement  showed  a  substantial 


BALANCE  SHEET  AUDIT— ASSETS  .83 

liability  for  borrowed  money.  It  seemed  incredible  that  a  working  capital 
invested  and  borrowed  of  more  than  the  amount  of  the  annual  sales  could 
be  correct,  but  that  is  what  this  report  showed.  Upon  closer  analysis  and 
further  information,  it  was  found  that  in  the  accounts  receivable  of  the 
firm  there  were  many  old  accounts  running  years  back,  which  they  were 
carrying  as  good  accounts,  and  also  substantial  sums  due  the  firm  from  the 
partners,  which  were,  in  other  words,  overdrafts.  When  the  statement 
was  all  boiled  down,  it  was  found  that  their  actual  capital  was  less  than 
one-half  that  reported  in  their  statement.  These  are  the  ''earmarks" 
which,  upon  close  observation  and  the  knowledge  of  credit,  prove  inval- 
uable to  one's  institution. 

It  is  vitally  important  in  examining  and  passing  upon  a  statement 
that  one  should  be  thoroughly  familiar  with  the  conditions  surrounding 
the  business  during  the  year.  Conditions  may  have  made  it  impossible  for 
any  concern  to  make  money,  and  where  a  concern  reports  a  gain  in  its 
capital,  one  owes  it  to  himself  and  to  his  institution  to  inquire  thoroughly 
and  closely  as  to  the  causes  which  produced  such  a  result  when  all  the 
conditions  were  adverse. 

As  an  example,  we  have  the  accounts  of  a  number  of  houses  in  the  same 
interior  city  in  identically  the  same  line  of  business,  and  while  the  amount 
of  their  capital  varies  (and,  consequently,  their  volume  of  business),  we 
can  each  year,  by  working  out  the  percentages,  see  which  concern  is  ob- 
taining the  best  results  upon  its  volume  of  business  and  the  amount  of  its 
capital. 

From  the  standpoint  of  good  banking  it  is  not  in  the  province  of  any 
bank  to  furnish  permanent  working  capital  for  any  one  of  its  depositors. 
A  bank  whose  liabilities  are  all  payable  on  demand  should  observe  closely 
the  well-established  rule  that  its  borrowers  should  at  some  time  during 
each  twelve  months  liquidate  their  indebtedness  to  the  bank  for  a  reason- 
able period  of  time.  In  my  opinion,  this  is  neither  unjust  nor  arbitrary, 
and  is  dictated  by  well-demonstrated  and  sound  banking  and  business 
logic. 

I  have  always  believed  that  an  independent  audit  by  a  firm  of  certified 
public  accountants  is  desirable.  And  from  the  standpoints  both  of  the 
borrower  and  the  lender,  it  is  wise  at  least  once  a  year  to  have  the  affairs 
of  a  firm  or  corporation  examined  and  audited  by  a  high-class  firm  of 
auditors. 

It  is  obvious  that  no  concern  can  have  a  "clean  up"  annually 
or  oftener  unless  its  current  assets  can  be  turned  into  cash  within 
a  reasonable  time.    Therefore,  before  the  auditor  commences  his 


84  AUDITING— GENERAL  PRINCIPLES 

verification  of  the  current  assets,  he  should  ascertain,  as  accur- 
ately as  possible,  the  normal  proportion  of  each  class  of  such 
assets  in  the  average  concern  in  the  same  line  of  business  as  that 
under  audit. 

With  this  as  a  starting  point  he  is  able  to  determine,  as  his 
work  progresses,  how  far  from  normal  the  concern  is.  This  in- 
formation should  be  of  the  greatest  value  to  his  client. 

The  attitude  of  the  lender  of  money  is  almost  invariably  in- 
fluenced entirely  by  the  relation  of  current  liabilities  to  current 
assets,  because  current  loans  are  not  supposed  to  be  made  on  fixed 
assets.  The  value  of  the  plant,  using  that  word  in  the  broad  sense, 
in  relation  to  its  cost  and  more  particularly  to  its  earning  capacity, 
is  a  factor  which  it  seems  should  be  given  careful  consideration  by 
the  lender.  It  would  be  better,  for  instance,  to  lend  money  to 
a  concern  which  had  a  plant  of  good  earning  capacity,  even  though 
its  liabilities  were  loo  per  cent  of  its  quick  assets,  than  to  a  con- 
cern whose  liabilities  apparently  amounted  to  only  50  per  cent  of 
its  quick  assets  but  which  had  a  poor  plant  and  which  was  not 
making  money.  There  is  a  direct  connection  between  plant  assets 
and  valuations  and  the  income  account  to  which  bankers  do  not 
always  give  enough  consideration.  This  subject  is  more  fully 
discussed  under  appropriate  titles. 


CHAPTER  VII 

BALANCE  SHEET  AUDIT— CURRENT  ASSETS 

The  verification  of  assets  usually  commences  with  current 
assets;  these  are  taken  up  in  the  order  in  which  they  appear  in  the 
balance  sheet.  In  this  chapter  will  be  discussed:  cash;  accounts 
and  notes  receivable;  investment  securities;  and  such  deferred 
charges  to  operations  as  are  properly  included  in  current  assets. 
Inventories  naturally  follow  accounts  and  notes  receivable  but 
for  convenience  the  discussion  is  deferred  to  separate  chapters 

Cash 

This  item  is  considered  under  the  following  heads : 

Cash  in  Bank. — If  no  notice  has  been  given  to  the  cKent's 
staff,  the  cash  should  be  balanced  as  soon  as  the  auditor  can  secure 
access  to  it.  The  bank  balances  should  be  verified  by  independent 
confirmation.  The  cash  transactions  since  the  date  of  the  bal- 
ance sheet  should  be  scrutinized  and  the  footings  proved  in  order 
that  the  balance  on  hand  as  stated  therein  may  be  shown  to  be 
correct. 

Where  the  currency  and  bank  transactions  are  kept  together 
in  the  cash  book  and  the  auditor  does  not  count  the  cash  until  a 
date  subsequent  to  the  close  of  the  fiscal  year,  he  must,  in  addition 
to  verifying  the  bank  balances  as  of  the  close  of  the  year,  verify 
them  as  of  the  date  of  the  count  of  cash.  This  is  absolutely  es- 
sential when  it  is  considered  that,  although  the  cash  on  hand, 
which  forms  only  part  of  the  balance  at  the  date  of  the  count,  is 
correct,  it  does  not  follow  that  the  total  cash  is  correct. 

When  the  audit  occurs  a  considerable  time  after  the  date  of 
the  balance  sheet,  it  is  customary  to  secure  certificates  from  the 
banks  covering  the  balances  as  of  the  closing  or  balance  sheet  date. 

85 


86  AUDITING— GENERAL  PRINCIPLES 

These  are  reconciled  with  the  books,  accepting  as  a  basis  the 
schedule  of  outstanding  cheques  shown  by  the  books. 

There  is  always  a  possibility  that  a  shortage  in  the  cash  at  the 
date  of  the  balance  sheet  may  have  been  concealed  by  the  omis- 
sion of  receipts  deposited  before  the  end  of  the  period,  included  in 
the  bank  balance  at  the  closing  date,  but  not  recorded  in  the 
cash  book  until  the  beginning  of  the  succeeding  period.  For  this 
and  other  reasons  the  cash  entries  subsequent  to  the  closing  date 
should  be  scrutinized.  Cheques  outstanding  at  the  closing  date 
should  be  carefully  examined  in  order  to  see  that  they  were 
properly  entered  on  the  proper  date  in  the  cash  account. 

It  is  particularly  important  to  trace  deposits  entered  as  made 
at  the  end  of  the  period  after  the  close  of  business  but  not  credited 
by  the  bank  until  afterwards.  Such  deposits  should  be  credited 
by  the  bank  on  the  succeeding  business  day;  if  not,  an  investiga- 
tion should  be  made.  Where  the  reconciliation  between  the  bank 
balance  and  the  cash  book  is  made  in  the  cash  book,  it  is,  never- 
theless, advisable  to  examine  the  cheque  stub  to  ascertain  that 
the  balance  as  shown  therein  is  in  agreement  with  that  in  the 
cash  book. 

Many  auditors  accept  bank  pass-books  as  conclusive  evidence, 
but  the  author  has  encountered  several  cases  of  fictitious  pass- 
books and  two  cases  where  the  genuine  pass-books  were  very 
cleverly  altered.  Therefore,  to  be  safe,  the  auditor  should  have 
one  of  his  own  staff  secure  the  pass-books  or  statements  from  the 
bank,  or  preferably,  have  the  confirmation  of  the  balances  mailed 
direct  to  him  by  the  banks.  A  prominent  firm  of  accountants 
failed  to  discover  a  defalcation  in  a  case  which  arose  in  1920 
because  the  verification  of  the  balance  went  to  the  company 
instead  of  the  auditors.  ^ 

The  auditor  should  satisfy  himself  that  the  cash  in  banks  is  free 
from  any  liens  or  offsets  and  that  it  may  be  withdrawn  on  demand. 

^  It  is  not  necessary  in  a  balance  sheet  audit  to  make  the  same  exhaustive 
examination  of  the  bank  account  as  in  a  detailed  audit,  but  the  auditor  must 
be  famihar  with  various  fraudulent  devices  which  are  fully  discussed  on  page 
502,  el  seq. 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  87 

Petty  Cash. — Where  the  petty  cash  balance  or  fund  called 
for  by  the  balance  sheet  is  small,  it  may  be  unnecessary  to  at- 
tempt to  account  for  it,  since  it  might  require  considerable  time  to 
inspect  and  prove  all  of  the  entries  between  the  closing  date  and 
the  time  of  the  audit.  Usually  a  scrutiny  of  the  subsequent  en- 
tries is  sufficient. 

If  the  balance  is,  say,  over  $100  it  should  be  verified  by  actual 
count  and  proof.  In  an  English  case  an  auditor  who  failed  to 
verify  a  petty  cash  balance  of  nearly  $4,000  was  held  to  have 
committed  a  breach  of  duty.    The  actual  balance  was  $150. 

The  balance  should  consist  of  actual  cash,  not  memoranda  or 
**cash  items."  A  cashier  who  is  carrying  questionable  items  as  a 
part  of  his  cash  balance  may  borrow  money  enough  on  the  closing 
date  to  enable  him  to  pay  the  entire  balance  into  bank,  or  to 
exhibit  the  cash  to  an  executive;  after  doing  so  the  cashier  can 
immediately  put  the  items  back  into  the  cash  drawer  and  again 
withdraw  the  cash.  If  there  is  any  suspicion  that  this  is  being 
done,  a  second  count  of  the  cash  on  hand  should  be  made  toward 
the  close  of  the  audit. 

Whether  this  part  of  the  work  proves  pleasant  and  satisfac- 
tory depends  on  the  auditor.  It  is  quite  possible  that  an  auditor, 
in  his  desire  to  jump  in  without  notice,  will  really  upset  a  cashier 
who  pursues  certain  routine  methods  of  handling  the  cash  and 
cash  records.  First  impressions  are  very  important,  and  it  never 
pays  to  disarrange  the  work  of  a  single  person  in  a  client's  office 
unless  a  definite  reason  exists  for  proceeding  offhand  and  with- 
out giving  notice.  If  the  client  does  not  inform  his  staff  that 
the  accounts  are  to  be  audited,  it  is  desirable  that  the  auditor 
take  advantage  of  the  opportunity  to  surprise  the  man  in  charge 
of  the  cash.  Probably  more  petty  frauds  are  disclosed  in  this 
manner  than  in  any  other,  for  too  many  men  are  unable  to  dis- 
tinguish between  their  personal  funds  and  those  of  their  em- 
ployers. Many  of  these  discrepancies  are  under  $100,  and  if  the 
cashier  is  given  time  to  put  his  cash  drawer  in  order,  the  shortage 
may  disappear.    It  may  be  argued  that  in  such  a  case  no  great 


88  AUDITING— GENERAL  PRINCIPLES 

harm  can  ensue,  because  there  is  no  actual  money  loss  to  the  cli- 
ent. No  greater  mistake  can  be  made,  however,  for  a  man  whose 
moral  sense  is  so  blunted  that  he  pilfers  a  few  dollars  is  on  the  high- 
way to  further  frauds  and  waits  only  an  opportunity  to  misappro- 
priate anything  of  larger  value  on  which  he  can  lay  his  hands. 

Usually  the  auditor  is  expected.  If  the  audit  is  a  periodical 
one,  the  approximate  time  of  commencing  is  known  in  advance. 
If  it  is  a  special  engagement,  in  most  cases  the  negotiations  with 
the  auditor  are  known  to  all  in  the  client's  office.  Here  the  audi- 
tor can  exercise  a  little  tact  or  diplomacy.  The  cashier  may,  for 
instance,  balance  his  cash  late  in  the  day,  and  if  it  is  much  of  a 
task  he  is  anxious  to  hurry  home  upon  striking  a  balance.  The 
wise  auditor  makes  it  a  point  to  tackle  him  first  thing  in  the  morn- 
ing at  a  time  when  the  memoranda  of  the  day  have  not  com- 
menced to  accumulate  and  when  the  cash  book  is  written  up  and 
the  footings  shown. 

Very  often  slips  of  paper,  tickets,  and  so-called  vouchers  make 
up  a  large  portion  of  the  "  cash  "  in  the  drawer.  In  all  cases  coimt 
the  actual  money  first,  then  list  the  memoranda.  This  record 
should  be  full  and  complete,  for  there  may  be  some  delay  before 
it  is  used  again.  Cases  are  known  where  unauthorized  tickets 
carried  as  cash  have  mysteriously  disappeared  immediately  after 
an  auditor's  count  of  the  drawer. 

If  there  is  a  difference  between  the  amount  on  hand  and  the 
balance  called  for  by  the  cash  book  or  the  round  sum  carried  in 
the  ledger  as  a  petty  cash  fund,  it  is  not  wise  to  assume  at  once 
that  there  is  something  wrong.  The  auditor  should  note  the 
cash  book  footings,  and  with  this  information  in  his  possession, 
together  with  his  count  of  the  cash  drawer,  he  can  afford  to  give 
the  cashier  a  chance  to  himt  for  the  difference.  If  the  cashier 
balanced  the  night  before,  the  error  may  be  in  the  auditor's  own 
figures.    If  a  shortage  exists,  it  should  develop  at  this  point. 

When  the  cash  balance  consists  of  several  bank  accounts  or 
funds,  care  must  be  taken  to  see  that  the  entire  balance  is  verified 
simultaneously.    Instances  are  known  where  auditors  have  been 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  89 

deceived  through  one  balance,  after  being  inspected,  having  been 
transferred  and  used  on  a  later  day  in  connection  with  another 
balance. 

Cash  in  Transit. — Special  attention  should  be  given  to  cash 
or  cheques  in  transit  or  said  to  be  in  transit  at  the  close  of  the 
period,  to  make  certain  that  the  items  are  in  order  or  that  the 
same  items  are  not  included  twice.  Where  cash  items  are  en 
route  from  a  branch  office,  the  auditor  can  verify  the  receipt  and 
entry  in  the  main  office  books  subsequent  to  the  close  of  the  period. 
Where  the  cash  item  is  en  route  to  the  branch  office  it  is  not  difficult 
to  ascertain  that  it  has  been  excluded  from  the  main  office  cash. 

A  practice  which  should  be  condemned  is  that  of  including 
the  receipts  of  the  first  few  days  after  the  close  of  the  period  in 
the  cash  of  the  previous  month,  reducing  accounts  receivable  by 
a  corresponding  amount.  It  is  contended  by  those  who  defend 
this  practice  that  these  payments  were  forwarded  to  them  by  the 
debtors  before  the  close  of  the  period  and  that  these  items  repre- 
sent cash  in  transit.  Nevertheless,  only  such  items  as  represent 
cash  on  hand  or  in  the  bank  at  the  close  of  the  period  should  be 
included  in  the  cash  balance. 

Bank  Overdrafts  Should  Not  be  Deducted  from  Bank 
Balances. — When  there  is  a  balance  in  one  bank  and  an  over- 
draft of  a  smaller  amount  in  another  bank,  it  would  seem  that 
the  overdraft  should  be  deducted  and  the  net  amoimt  shown  as 
the  balance  in  banks;  in  most  cases,  however,  this  procedure  will 
not  reflect  actual  conditions.  Many  banks  require  minimum 
balances,  so  that  apparently  free  balances  are  not  free  in  fact. 
Overdrafts  must  be  made  good,  and  when  it  is  obvious  that  they 
can  only  be  made  good  by  borrowing,  overdrafts  should  be  in- 
cluded among  accounts  payable. 

Accounts  Receivable 

The  term  ''accounts  receivable,"  when  used  without  quah- 
fication  in  a  balance  sheet,  means  an  aggregate  amount  due  from 


90  AUDITING— GENERAL  PRINCIPLES 

trade  debtors,  reduced  by  adequate  reserves  for  bad  and  doubtful 
accounts,  and  excluding  accounts  which  mature  beyond  the  length 
of  credit  usually  extended  in  the  industry  with  which  the  con- 
cern is  most  closely  identified. 

Other  debts  may  be  due  which  are  legitimate  current  assets  but 
which  cannot  truthfully  be  classified  as  good  and  due  from  trade 
debtors,  which  have  been  sold  on  the  usual  trade  terms.  The 
aggregate  of  such  other  items  properly  classified  should  be  sepa- 
rately stated  on  the  balance  sheet  so  that  no  one  will  be  deceived. 

It  is  not  necessary  to  state  in  published  balance  sheets  the 
gross  amount  of  accounts  receivable  and  the  reserves  to  be  de- 
ducted therefrom.  It  is  information  of  interest  to  competitors 
more  than  to  anyone  else.  Opinions  differ  as  to  when  to  charge 
off  doubtful  accounts.  Some  concerns  charge  off  promptly, 
others  carry  accounts  until  the  last  possible  dollar  is  collected. 
Large  gross  amounts  and  large  reserves  may  give  rise  to  false  im- 
pressions regarding  the  aggregate  of  losses  sustained.  It  is  good 
accoimting  practice  to  omit  the  amount  of  reserves.  It  is  proper 
to  state  that  accounts  receivable  are  "net  of  reserves,"  but  it  is 
not  necessary,  because  an  unquahfied  certificate  carries  such  a 
Statement  by  impHcation.  Reserves  for  cash  discounts  also 
should  be  deducted.''  There  is  not  the  same  uncertainty  about 
this  item  because  most  cash  discounts  are  determinable  before 
the  books  are  closed.  For  this  reason  the  reserve  for  cash  dis- 
counts should  not  be  merged  or  classed  with  the  reserve  for  doubt- 
ful accounts.    One  is  certain,  the  other  is  uncertain. 

Other  reserves,  such  as  rebates  to  be  paid  or  allowed  after 
customers  buy  specified  quantities,  volume,  or  amounts,  may 
have  to  be  set  up.  When  not  ascertainable  for  the  current  period, 
but  probable,  some  allowance  must  be  made  and  deducted  from 
gross  sales  in  the  current  period.  Such  a  deduction  may  not  be 
proper  in  computing  net  income  for  tax  purposes.  When  the 
accrued  liability  is  determinable  with  reasonable  accuracy,  the 


2  See  discussion  on  pages  231  and  331  regarding  differentiation  between 
cash  discounts  of  less  and  more  than  2  per  cent. 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  9I 

entries  should  be  made  as  for  other  accrued  but  unpaid  habili- 
ties.  Likewise,  such  reserves  as  those  for  collection  expenses 
should  be  entered  as  accrued  liabilities  and  not  as  contingent 
reserves. 

The  decisions  of  the  courts  and  good  accounting  practice  agree 
that  net  income  for  a  certain  period  cannot  properly  be  deter- 
mined unless  and  until  the  accounts  receivable  are  appraised  and 
reduced  to  their  actual  value.  Any  contention  that  "gross"  and 
"net"  income  mean  the  same  thing  until  there  is  a  final  deter- 
mination of  value  is  fallacious.  The  proper  rule  is  to  include  in 
current  net  income  only  such  gross  income  as  will  be  converted 
into  the  equivalent  of  cash.  To  set  up  in  one  period  gross  sales, 
or  income,  aggregating  a  given  amount,  and  to  include  in  a  suc- 
ceeding period  the  deductions  therefrom,  is  bad  law  and  bad  ac- 
counting. If  accounts  and  claims  are  so  uncertain  that  the  net 
value  cannot  be  determined  or  estimated  with  reasonable  accu- 
racy, they  should  not  be  set  up  as  assets  at  all. 

Trade  Debtors. — When  the  item  "accounts  receivable"  ap- 
pears without  qualification  in  a  balance  sheet,  those  who  rely  on 
the  balance  sheet  are  justified  in  assuming  that  the  item  repre- 
sents a  current  asset,  fully  collectible  within  a  period  usual  to  the 
trade  or  industry  with  which  it  is  most  nearly  identified,  and  only 
containing  items  due  from  individuals  or  concerns  not  a  part  of 
or  connected  with  the  business  itself;  in  other  words,  accounts  due 
from  the  public. 

In  a  long-established  business  having  fairly  constant  sales, 
the  accounts  can  be  valued  on  a  basis  of  past  results.  Ascertain 
the  percentage  of  bad  accounts  in  past  years  and  apply  this  per- 
centage to  all  sales  up  to  the  closing  date.  When  market  prices 
of  commodities  are  declining,  accounts  receivable  which  are 
good  under  ordinary  circumstances  may  require  special  atten- 
tion; past  experience  may  not  be  a  safeguard.  A  large  fur 
concern  which  had  been  successful  sold  furs  in  February,  1920, 
to  the  extent  of  $22,000,000.    Only  one-half  of  the  accounts 


92  AUDITING— GENERAL  PRINCIPLES 

had  been  collected  within  a  year;  the  balance  is  reported  to  be 
uncollectible.  ^ 

The  sales,  for,  say,  the  last  month,  should  be  scrutinized  (not 
footed)  to  ascertain  whether  or  not  there  is  any  evidence  of  pre- 
dating, billing  to  fictitious  customers,  or  including  as  sales  at  full 
prices  consigned  goods  or  goods  sent  on  approval.  It  may  be 
found  that,  in  good  faith,  consigned  goods  are  included  among  the 
current  sales,  following  the  past  custom  of  the  concern,  but  this 
does  not  justify  the  practice,  which  results  in  anticipating  profits 
that  have  not  been  earned.  It  also  improperly  increases  accounts 
receivable. 

Accounts  current  should  be  obtained  for  all  consignment  ac- 
counts. Any  unsold  goods  at  time  of  closing  should  be  added 
to  the  inventory  and  priced  on  the  same  basis  as  the  rest  of  the 
inventory.  If  the  goods  are  salable  and  practically  sure  to  be 
sold,  accrued  charges  thereon,  paid  by  the  consignor,  such  as 
freight  and  insurance,  may  be  added  to  the  inventory  prices. 

If  past  experience  is  not  available,  and  in  a  period  of  abnormal 
conditions  such  as  obtained  during  and  after  the  war,  the  out- 
standings must  be  valued  on  their  merits.  The  experienced  audi- 
tor has  a  general  familiarity  with  the  normal  volume  of  outstand- 
ings which  various  classes  of  business  and  different  concerns  in 
the  same  line  of  business  are  expected  to  carry,  and  he,  for  his 
own  information,  should  compare  the  relative  outstandings  of 
each  business  to  the  gross  sales.  The  value  of  such  a  comparison 
is  apparent  at  a  glance,  for  negligence  and  laxity  stand  revealed 
in  a  manner  which  might  not  be  apparent  in  a  routine  audit.  The 
best  method  of  collating  such  data  is  to  compile  statistics  cover- 
ing gross  and  net  figures  and  the  percentages  based  thereon  at  the 
close  of  each  audit.  In  time  a  vast  quantity  of  information  will 
be  available,  at  a  moment's  notice,  for  comparative  purposes. 

The  auditor  must  not  hesitate  to  use  his  own  judgment  when 
abnormal  conditions  prevail.    Many  merchants  took  advantage 


3  Financial  Chronicle,  May  21,  192 1,  Vol.  ii2,  Part  2,  page  2196. 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  93 

of  the  moratorium  in  Cuba  and  postponed  the  payment  of  their 
accounts.  The  attitude  of  creditors  in  the  United  States  de- 
pended on  the  tax  situation  and  on  the  showing  which  it  was  de- 
sired to  make.  Those  who  had  large  profits  were  anxious  to 
charge  off  the  accounts  as  bad;  those  who  had  no  taxable  profits 
were  anxious  to  carry  the  accounts  as  wholly  good.  An  auditor 
could  not  justify  two  certificates  of  audit  in  one  of  which  an  ac- 
count due  from  A  and  Company  of  Cuba  was  charged  off  while 
in  the  other  A  and  Company's  account  was  carried  as  fully  col- 
lectible. No  matter  how  great  the  difficulty  in  arriving  at  a  de- 
cision, the  auditor  would  carry  A  and  Company  in  both  balance 
sheets  as  good,  partly  good,  or  as  bad,  and  as  in  other  cases  he 
would  find  that  the  arguments  advanced  by  his  clients  were 
strongly  influenced  by  the  showing  to  be  made.  When  dealing 
with  only  one  client,  he  must  take  cognizance  of  the  unreliability 
of  such  arguments. 

When  the  Hst  of  open  balances  is  compared  with  the  sales 
ledgers  it  should  be  noted  whether  or  not  the  balances  are  repre- 
sented by  specific  invoices  of  a  recent  date;  if  not,  the  balances 
should  be  analyzed.  An  old  item  in  a  running  account  or  a  bill 
partly  paid,  followed  by  others  fully  paid,  usually  means  that  an 
allowance  has  been  or  will  be  made,  or  that  a  defalcation  exists. 

When  the  accounts  are  few  in  number  but  large  in  amount, 
they  may  be  valued  separately. 

When  it  has  been  decided  that  an  analysis  must  be  made,  the 
work  must  of  necessity  be  entrusted  to  a  junior  with  specific  in- 
structions to  divide  the  balances  into,  say: 

Over  30  days 
Over  60  days 
Over  90  days 
Special 

Discretion  must  be  used  in  making  this  division.  Generally  the 
total  credits  to  the  close  of  the  period  under  review  are  applied 
against  a  similar  amount  of  debit  items  and  the  items  not  so 


94  AUDITING— GENERAL  PRINCIPLES 

canceled  are  divided  into  the  foregoing  classes.  As  some  of  the 
credits  so  applied  may  include  payments  or  other  credits  applic- 
able to  recent  sales  which  would  not  be  classed  in  the  30-,  60-,  or 
90-day  items,  it  can  be  seen  that  the  mere  mechanical  result  ob- 
tained from  the  aging  of  the  accounts  may  be  of  doubtful  value. 
This  rule  need  not  be  interpreted  literally  when  it  is  unnecessary. 
The  rule,  however,  is  a  good  one  and  must  be  observed  in  spirit, 
otherwise  the  auditor  subsequently  may  be  charged  with  negli- 
gence. Accounts  which  are  quite  old  are  worthless  and  the  audi- 
tor is  justified  in  writing  them  off  unless  a  very  strong  argument  is 
presented,  supported,  whenever  necessary,  by  documentary  evi- 
dence. 

When  it  is  considered  that  in  some  cases  several  himdred  or 
even  thousand  accounts  are  listed  in  this  process,  it  can  be  seen 
that  it  should  be  resorted  to  only  in  very  special  instances.  The 
results  obtained  from  this  process,  to  be  of  value,  must  be  applied 
with  due  consideration  to  the  policies  of  the  concern  and  the 
abihty  of  the  credit  manager. 

In  lieu  of  the  foregoing  the  auditor  may  secure  data  to  value 
the  accounts  by  simply  making  a  designating  mark  on  the  trial 
balance,  or  the  Hst  of  balances,  against  those  items  which  appear 
to  be  overdue.  He  should  subsequently  make  inquiries  of  the 
credit  manager  regarding  such  items.  From  the  information 
secured,  a  decision  can  be  made  as  to  the  percentage  of  each  over- 
due account  which  should  be  reserved  for  doubtful  accounts. 

It  is  a  rule  of  law  that  assent  to  the  correctness  of  a  balance 
may  be  inferred  from  the  retention  of  an  account  rendered  with- 
out objection  being  made  within  a  reasonable  time.  The  burden 
of  impeaching  the  accuracy  of  the  account,  for  fraud  or  for  mis- 
take, is  cast  upon  the  complaining  party;  but  the  only  proper  test 
of  ability  to  pay  is  payment,  and  where  this  is  delayed  an  unreason- 
able length  of  time,  the  inference  is  that  it  is  lacking. 

The  auditor  must  ascertain  whether  any  accounts  are  pledged 
or  assigned.  This  is  frequently  done  without  any  record  thereof 
being  made  in  the  books. 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  95 

The  following  suggestions  will  be  found  useful  in  fixing  upon 
a  valuation  of  overdue  trade  accounts: 

1.  Have  the  terms  of  credit  been  habitually  ignored?  If  so, 
the  debtors  may  be  perfectly  good,  but  such  accoimts  should  be 
given  special  attention  by  the  credit  manager. 

2.  If  payments  are  being  made  on  account,  are  the  balances 
being  increased  or  decreased?  If  the  former,  this  is  prima  facie 
evidence  that  debtors  are  approaching  the  time  when  all  pay- 
ments will  stop.  This  is  a  class  of  accounts  which  deserves  more 
attention  than  it  receives.  The  auditor  should  keep  this  point  in 
mind,  and  a  word  of  advice  from  him  may  save  ultimate  loss. 
Salesmen  rehnquish  these  accounts  very  reluctantly,  but  they 
are  not  the  best  authorities  on  the  ability  of  debtors  to  pay. 

3.  If  credit  has  been  stopped  and  no  recent  collections  appear, 
ascertain  if  the  accoimts  have  been  placed  with  attorneys  for 
collection. 

4.  If  in  the  hands  of  attorneys,  ask  for  the  correspondence. 
Unless  frequently  checked  up,  the  debtors  will  not  pay.  So  long 
as  their  money  lasts,  or  so  long  as  they  desire  to  preserve  their 
credit,  debtors  pay  those  who  press  them  hardest. 

5.  If  debtors  who  have  paid  cash  commence  to  give  notes, 
ascertain  whether  sound  reasons  therefor  have  been  offered  and 
whether  the  change  has  been  approved  by  someone  in  authority. 

In  most  cases,  those  in  charge  of  the  outstanding  accounts 
are  too  optimistic.  Nevertheless,  their  knowledge  must  be  util- 
ized by  the  auditor.  He  discounts  their  estimates  as  much  as  is 
necessary  and  draws  his  own  conclusions. 

A  certificate  as  to  outstanding  accounts  should  not  be  given 
unless  the  schedules  of  accounts  have  been  compared  in  detail 
with  the  customers  ledgers,  and  the  footings  of  the  schedules 
verified.  The  procedure  in  this  case  should  be  the  same  whether 
or  not  a  controlling  account  is  kept,  but  this  rule  may  be  modified 
if  the  concern  in  question  has  a  very  large  number  of  open  ac- 
counts which  are  subject  to  internal  check. 

In  a  balance  sheet  audit  the  auditor  is  more  concerned  with  the 


96  AUDITING— GENERAL  PRINCIPLES 

value  of  the  accounts  as  a  whole  than  with  the  balancing  of  the 
books,  but  in  all  cases  one  phase  of  balancing  must  be  kept  in 
mind.  When  the  accounts  receivable  controlling  account  ex- 
ceeds the  aggregate  of  the  detailed  schedules,  the  auditor  is  on 
notice  that  a  defalcation  has  taken  place  or  that  some  other 
irregularity  exists.  Unless  the  cause  of  the  discrepancy  is  dis- 
covered, a  book,  and  probably  an  actual,  loss  will  be  realized. 
The  total  amount  to  be  collected  will  depend  on  the  individual 
accounts,  not  on  the  controlling  account,  and  if  the  latter  cannot 
be  fully  supported  by  good  accounts  the  excess  must  be  written 
off. 

Allowance  must  be  made  for  discounts  which  are  deducted  by 
customers  and^ which,  although  termed  cash  discounts,  are  greater 
than  a  concern  pays  for  the  use  of  money.  In  a  stable  business  it 
is  usually  possible  to  deduct  a  fixed  percentage  from  all  the  out- 
standings. If  special  discounts  are  given,  it  may  be  necessary  to 
classify  the  balances  before  determining  the  deductions  to  be 
made.  Current  sales  may  have  been  made  with  datings  some 
days  in  the  future,  the  discount  period  in  which  case  may  termin- 
ate, say,  forty  or  seventy  days  after  the  date  of  the  invoice  instead 
of  ten  days.  If  freight  allowances  are  permitted,  care  must  be 
taken  to  see  that  adequate  provision  is  made  therefor. 

Miscellaneous  Receivables. — The  foregoing  comments 
refer  to  trade  debtors  and  apply  chiefly  to  mercantile  and  manu- 
facturing concerns.  The  same  principles  govern  the  verification 
of  the  outstandings  in  enterprises  which  are  not  generally  classi- 
fied as  mercantile  or  manufacturing. 

For  instance,  real  estate  agents,  as  well  as  manufacturing 
estabHshments,  may  show  on  their  balance  sheets  large  items 
which  represent  real  estate  rentals  uncollected.  Likewise,  stock- 
brokers carry  very  large  assets  which  represent  balances  due  from 
customers.  The  balance  sheets  of  financial  institutions  and  of 
enterprises  which  own  investment  securities  contain  items  of 
interest  and  dividends  due,  but  not  collected.    The  balance  sheets 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  97 

of  commission  houses  show  commission  and  other  charges  as 
accounts  receivable. 

In  all  cases  the  auditor  must  satisfy  himself: 

1.  That  the  items  constituting  the  balances  are  bona  fide, 

and 

2.  That  the  balances  have  not  been  liquidated  in  part  or  in 

whole. 

The  rules  for  verifying  these  requirements  do  not  differ  in 
principle  from  the  rules  enumerated  for  testing  the  accuracy  of 
balances  due  from  trade  debtors. 

Amounts  Due  from  Affiliated  Companies. — Amounts  due 
from  affiliated  companies  should  not  be  combined  with  those  due 
from  trade  debtors  and  shown  as  one  amount  on  the  balance  sheet, 
because  the  use  of  the  expression  *' trade  debtors"  or  *' accounts 
receivable,"  if  it  is  not  qualified,  will  be  understood  by  the  per- 
son who  reads  the  balance  sheet,  and  reasonably  so,  to  mean 
accounts  due  from  customers.  Advances  to  affiliated  companies, 
therefore,  should  be  stated  separately,  and  they  should  not  be 
included  in  the  current  assets  except  to  the  extent  that  they  may 
be  represented  by  the  net  current  assets  of  a  subsidiary.  In  some 
cases  all  or  part  of  the  advances  may  be  represented  by  perma- 
nent improvements  or  other  fixed  assets  of  a  subsidiary,  and  if 
such  is  the  case,  that  part  of  the  advance  so  covered  by  fixed 
assets  of  the  subsidiary  should  appear  in  that  section  of  the  bal- 
ance sheet  in  which  the  fixed  assets  of  the  parent  company  are 
stated. 

The  foregoing  comments  apply  to  a  balance  sheet  of  the  parent 
or  holding  company  in  which  the  subsidiaries'  accounts  would  not 
be  consolidated  in  the  usual  manner  with  those  of  the  parent 
company.  It  is  generally  preferable  to  prepare  a  consolidated 
balance  sheet,  because  no  question  can  then  arise  as  to  the  group- 
ing or  position  on  the  balance  sheet  of  the  subsidiary  companies' 
assets  and  liabilities,  which  will  be  combined  automatically  with 
like  assets  and  liabilities  of  the  parent  company. 

VOL.  I — 7 


98  AUDITING— GENERAL  PRINCIPLES 

This  rule  is  inflexible  in  every  case  where  the  amount  is  other 
than  negligible.  If  objection  is  made  on  the  ground  that  it  un- 
favorably affects  the  balance  sheet,  that  is  merely  corroboration 
of  the  sound  reasons  upon  which  the  rule  is  based. 

When  a  consolidated  balance  sheet  is  made,  such  items,  of 
course,  disappear,  and  no  issue  is  raised.  When  a  consoKdated 
balance  sheet  is  not  prepared,  the  rule  stated  on  page  89  governs, 
viz.,  the  term  ''accounts  receivable"  when  stated  without  reserva- 
tion means  that  the  aggregate  thereof  is  due  from  the  public  and 
that  the  entire  amount  will  be  collected  within  a  reasonable  time. 
Accounts  due  from  affiliated  or  subsidiary  concerns  may  be  col- 
lected in  due  course  or  may  have  been  collected  before  the  balance 
sheet  is  issued,  but  the  principle  is  precisely  the  same  as  if  no 
collection  had  been  made.  The  chief  reason  for  the  rule  is  to 
inform  those  who  see  or  rely  on  the  balance  sheet  whether  or  not 
there  was  at  the  date  of  the  balance  sheet  any  amount  due  from 
affiliated  or  subsidiary  concerns. 

It  can  be  shown,  if  desirable,  that  the  latter  are  able  to  pay 
and  will  continue  to  be  able.  Even  so,  it  is  again  emphasized 
that  those  who  may  rely  on  the  balance  sheet  wish  to  form  their 
own  conclusions  or  make  their  own  inquiries  regarding  all  ac- 
counts carried  as  current  assets  due  from  what  are  known  as 
affiliated  interests. 

When  the  amount  is  trifling  it  should  be  included  among  other 
accounts  receivable,  following  the  general  rule  that  small  items 
of  assets  or  liabilities  should  not  be  separately  stated  in  a  balance 
sheet. 

Naturally,  the  question  arises :  What  affiliation  must  exist  in 
order  to  require  a  separation  of  items?  It  is  not  possible  to  fix 
a  percentage  of  ownership  because  the  point  at  issue  depends  more 
on  control  than  on  ownership.  Ordinarily,  the  ownership  of  more 
than  a  majority  of  the  stock  of  an  affiliated  concern  is  necessary 
to  insure  control,  but  in  many  cases  full  control  is  exercised  al- 
though there  is  less  than  a  majority  ownership.  If  a  definite  rule 
is  needed,  it  might  be  stated  to  be  that  when  there  is  more  than 


I 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  99 

50  per  cent  ownership  in  an  affiliated  concern,  the  debts  due  from 
such  concerns  must  be  stated  separately  in  the  balance  sheet; 
when  there  is  less  than  50  per  cent  ownership  and  it  appears  that 
control  is  exercised,  the  items  should  be  separated;  when  there  is 
less  than  50  per  cent  ownership  and  it  does  not  appear  that  con- 
trol is  exercised,  the  auditor  may  use  his  discretion. 

Amounts  Due  from  Officers  or  Employees. — The  re- 
marks under  "amounts  due  from  affiliated  companies"  apply  with 
equal  force  to  amounts  due  from  officers,  directors,  stockholders, 
employees,  or  others  connected  with  the  concern.  The  amounts 
shown  by  the  books  to  be  due  may  be  perfectly  good  or  in  fact 
may  have  been  paid  immediately  after  the  date  of  the  balance 
sheet.  Nevertheless,  if  the  amounts  are  at  all  substantial  they 
must  be  separately  stated  on  the  balance  sheet.  Former  ad- 
vances or  loans  may  have  been  repaid  but  that  does  not  mean 
that  other  advances  will  be  repaid.^  Those  who  rely  on  balance 
sheets  wish  to  know  about  customs  as  well  as  about  figures. 

Auditors  will  do  well  to  consider  that  several  members  of  the 
American  Institute  of  Accountants  have  been  suspended  from 
membership  for  failure  to  state  separately  on  balance  sheets 
amounts  due  from  officers  and  others,  when  the  amounts  due 
were  substantial  and  those  who  relied  on  the  balance  sheets  were 


4  "Usually  such  a  condition  is  not  indicative  of  fraud.  It  is  merely  evi- 
dence of  an  indifference  to  the  legal  requirements  in  regard  to  corporate  funds. 
It  may  indicate  a  laxness  so  great  as  to  induce  fraud  on  the  part  of  the  officers. 
The  auditor  should  call  attention  to  the  fact  that  the  most  charitable  interpre- 
tation which  can  be  put  on  such  drawings  is  to  call  them  loans,  which  would  be 
subject  to  recovery  if  required  for  the  payment  of  liabilities,  and  that  the  least 
charitable  interpretation  is  to  call  theni  misappropriations.  If  the  withdrawals 
are  legitimate  they  should  be  authorized;  in  any  event  the  attention  of  the 
directors  should  be  called  to  their  irregularity.  Debit  balances  of  this  kind  are 
often  found  in  close  corporations,  particularly  if  the  business  has  previously 
been  conducted  as  a  partnership.  The  former  partners,  having  become  ac- 
customed to  taking  drawings,  continue  to  do  so,  not  realizing  that  partners 
may  be  allowed  to  take  drawings  in  any  free  and  easy  manner  they  desire, 
while  the  profits  of  a  corporation  can  be  legally  divided  only  by  the  formal  dec- 
laration of  a  dividend.  If  these  accounts  represent  drawings  against  an  ac- 
cumulated surplus  account,  the  auditor  should  advise  the  declaration  of  a  divi- 
dend to  cover,  so  as  to  legalize  the  withdrawals  and  relieve  the  stockholders  of 
liability  to  creditors  on  account  thereof  in  the  event  of  future  financial  difficul- 
ties."    (H.  A.  Finney,  Journal  of  Accountancy,  March,  1921,) 


100  AUDITING— GENERAL  PRINCIPLES 

deceived.  When  any  doubt  exists  let  this  question  settle  it: 
Are  the  items  in  question  due  from  the  pubHc,  that  is,  those  with 
whom  all  relations  are,  in  effect,  at  ''arm's  length,"  or  are  the 
relations  such  that  affiliation  or  self  interest  or  internal  factors 
affect  or  may  affect  prompt  and  full  collection?  As  to  whether  or 
not  amounts  due  from  employees  should  be  included  in  current 
assets  depends  on  circumstances.  If  the  auditor  is  sure  that  the 
accounts  will  be  repaid  and  will  not  be  replaced  by  similar  items 
it  would  be  proper  to  include  such  accounts  in  current  assets.  Ac- 
counts due  for  stock  sold  to  employees  on  a  partial  payment  plan 
may  or  may  not  be  current  assets.  The  most  important  point  to 
observe  is  to  state  such  accounts  separately  in  the  balance  sheet. 

Segregation  of  Accounts  and  Notes  Not  Due  Within 
One  Year. — The  item  ''accounts  and  notes  receivable"  appears 
second  in  the  list  of  current  assets  because  of  the  expectation  that 
in  point  of  convertibility  into  cash  the  item  ranks  next  to  the 
cash  item.  Those  who  use  balance  sheets  are  justified  in  such  an 
inference ;  therefore  it  is  proper  that  there  should  be  a  segregation 
of  any  items  which  probably  will  not  or  cannot  be  collected 
within  a  reasonable  time — say,  one  year  from  the  date  of  the 
balance  sheet.  In  the  case  of  concerns  selling  goods  or  real  estate 
on  the  instalment  plan,  everyone  is  on  notice  that  collections 
from  the  receivables  will  be  spread  over  a  long  period  of  time;  but 
in  the  case  of  industries  where  the  usual  terms  of  credit  are  60  or 
90  days,  the  designation  "current"  would  be  a  misnomer  if  any 
substantial  part  of  the  accounts  of  any  one  concern  were  not  due 
for  nine  months  or  a  year.  The  point  is  specifically  covered  in 
practically  all  deeds  of  trust  wherein  the  term  "current  assets" 
is  defined,  and  under  the  terms  of  which  accounts  and  notes 
receivable  may  not  be  included  unless  good  and  collectible  and 
due  and  payable  within  one  year. 

Fictitious  Accounts  Receivable. — In  many  balance  sheets, 
accounts  receivable  from  customers  are  mingled  with  other  debit 
balances.     The  latter  may  include  advances  to  salesmen  and 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  lOI 

others;  overdrafts  of  officers;  claims  against  railroads,  creditors, 
or  the  government  for  alleged  overcharge  of  duties;  prepayments 
on  purchase  contracts;  guarantees;  etc.  Not  infrequently  con- 
siderable amounts  are  included  which  represent  charges  to  ven- 
dors for  goods  returned.  Such  balances  are  rarely  settled  in  cash. 
Where  the  open  items  consist  of  cash  debits,  it  may  be  assumed 
that  purchase  invoices  exist  which  have  not  yet  been  credited  to 
the  account.  The  distinction  to  be  drawn  here  is  that  instead  of 
dealing  with  the  accoimts  in  groups,  each  individual  account 
must  be  scrutinized  and  valued  on  its  merits. 

Sometimes  these  so-called  accounts  receivable  are  not  "receiv- 
able" at  all,  but  are  merely  advances  under  contracts,  the  goods 
or  materials  purchased  not  being  delivered  at  the  date  of  the  bal- 
ance sheet.    One  experience  of  the  author's  illustrates  this  point. 

An  iron  company  was  under  contract  to  purchase  large  quan- 
tities of  ore  and  to  make  periodical  payments  irrespective  of  ac- 
tual dehveries,  except  that  the  ore  was  all  to  be  deUvered  within 
one  year.  After  the  payments  commenced  and  before  any  ore 
was  received,  its  books  were  closed.  The  payments  were  in- 
cluded among  the  regular  accounts  receivable  in  the  balance 
sheet.  The  author  separated  the  items  and  set  up  a  new  balance 
sheet  showing  the  advances  under  their  proper  caption. 

The  balance  sheet  was  to  be  used  as  a  basis  of  credit,  and  a 
banker  or  creditor  would  have  been  grossly  deceived  if  the  adjust- 
ment had  not  been  made,  since  the  item  "accounts  receivable" 
in  a  balance  sheet,  stated  without  qualification,  may  be  regarded 
as  one  of  the  best  current  assets;  whereas  in  this  case  not  one  cent 
could  be  realized  on  this  item  until  the  ore  was  shipped  and  re- 
ceived, converted  into  iron,  the  iron  sold,  and  the  proceeds 
collected.  In  other  words,  it  was  a  deferred  asset  of  the  most 
extreme  kind.  The  president  of  the  company  strenuously  ob- 
jected to  the  restatement  of  the  balance  sheet,  saying  that  it  had 
always  been  done  in  the  old  way  and  that  the  change,  if  made, 
would  attract  unfavorable  attention. 

Although  changes  in  the  form  of  annual  statements,  due  to 


102  AUDITING— GENERAL  PRINCIPLES 

previous  erroneous  practices,  are  always  to  be  regretted,  yet  it  is 
clear  that  the  facts  must  be  shown  if  known.  In  this  instance  the 
balance  sheet  was  restated  in  correct  form,  and  has  been  so  stated 
from  that  time. 

In  another  instance  a  silk  merchant  had  made  advances  to  a 
manufacturer.  These  advances  amounted  to  several  hundred 
thousand  dollars  and  were  included  in  the  aggregate  of  his  ac- 
counts receivable  without  any  explanation.  He  had  secured  a 
large  line  of  credit  based  chiefly  on  his  outstandings.  Investiga- 
tion disclosed  the  fact  that  the  advances  carried  with  them  the 
ownership  of  several  mills  which  were  being  conducted  at  a  loss, 
so  that  the  accounts,  instead  of  being  current  accounts  receivable 
worth  their  face  value,  represented  real  estate,  machinery,  raw 
material,  manufactured  and  finished  goods,  the  highest  total 
value  of  which  fell  far  short  of  the  aggregate  advances. 

In  a  recent  bankruptcy  case  it  was  found  that  among  the 
accounts  receivable,  as  theretofore  carried  on  the  balance  sheet, 
there  was  an  item  of  $58,000,  representing  the  amount  of  an  em- 
bezzlement committed  by  an  employee  seven  years  previously. 
Part  of  the  time  the  account  was  transferred  from  *' accounts  re- 
ceivable" to  *' investments."  It  was  explained  that  it  was  the 
intention  of  the  company  to  deduct  an  amount  each  year  from 
the  profits  until  the  entire  sum  was  cleaned  up.  It  certainly  re- 
quired a  vivid  imagination  to  call  this  item  a  current  asset! 

The  caption  *' accounts  receivable"  is  sometimes  used  to 
cover  deferred  charges  to  operating,  such  as  rents  paid  in  ad- 
vance and  similar  items.  In  no  sense  of  the  word  are  these  ac- 
counts receivable.  The  test  is :  Will  the  balances  be  liquidated  in 
cash  in  due  course?  Of  course  nothing  can  be  realized  by  a  going 
concern  from  such  accounts,  and  in  the  case  of  a  liquidation  no 
funds  arising  therefrom  will  be  available  for  the  payment  of  debts. 

Instalment  Accounts 

In  several  hues  of  business  sales  are  made  or  contracts  are 
executed  under  conditions  which  require  time  to  consummate,  or 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  103 

they  are  payable  in  instalments.  It  is  customary  to  charge  the 
total  contract  to  the  debtor  and  to  credit  the  collections  on  ac- 
count as  they  are  made.  Experience  has  demonstrated  that 
many  of  these  contracts  are  not  carried  out,  in  which  case  the 
balances  due  are  uncollectible.  If  a  business  has  been  established 
for  a  number  of  years,  past  results  may  be  used  as  a  guide  in 
valuing  the  outstandings,  but  if  the  business  has  been  recently 
established,  great  care  must  be  taken.  The  first  point  to  consider 
is  the  character  of  the  contract  and  description  of  the  subject 
matter. 

In  the  case  of  piano  contracts  where  a  material  first  payment 
is  collected,  and  where  the  piano  can  be  taken  back  without  ex- 
cessive cost,  the  loss  is  small;  it  is  large  in  the  case  of  contracts 
for  correspondence  courses  and  books.  It  is  not  usually  con- 
sidered worth  while  to  attempt  to  reclaim  books  and  lesson 
papers,  although  title  does  not  pass  until  the  final  payment  is 
made,  nor  is  it  usually  worth  while  to  enter  suit  for  collection  of 
the  balance  due.  Therefore,  in  all  cases  where  this  class  of 
contracts  is  entered  at  the  full  purchase  price,  a  considerable 
reserve  must  be  provided  for  bad  debts  and  collection  expenses. 

It  is  permissible  to  include  good  accounts,  less  proper  reserves, 
among  current  assets.  Unless  there  is  some  special  reason 
for  it,  it  is  not  necessary  to  classify  the  accounts  according  to 
maturity  dates  unless  the  average  life  of  the  accounts  exceeds 
that  of  representative  concerns  in  the  same  kind  of  business. 
Those  who  use  the  balance  sheets  should  have  full  knowledge  of 
the  facts,  but  it  is  not  always  considered  necessary  to  disclose 
too  much  information  on  the  balance  sheet.  Those  who  are  en- 
titled to  it  can  readily  secure  information  such  as  the  average 
life  of  the  outstanding  accounts. 

The  United  States  Treasury  has  made  it  possible  for  concerns 
selling  on  the  instalment  plan  to  postpone  the  taking  (and  taxa- 
tion) of  profits  until  collections  are  made  in  cash.  ^    Prior  to  ac- 

5  For  details  of  the  deferred  profit  method  and  instructions  for  changes 
in  accounts  and  balance  sheet,  see  Income  Tax  Procedure,  192 1,  pages  363-373. 


I04  AUDITING— GENERAL  PRINCIPLES 

tion  by  the  Treasury  it  was  considered  good  accounting  practice 
to  treat  profits  as  earned  in  the  period  during  which  sales  were 
made,  adequate  reserves  being  set  up  for  bad  debts  and  collection 
expenses.  As  most  concerns  benefit  largely  by  the  special 
favor  of  the  Treasury,  it  may  be  assumed  that  their  income  state- 
ments and  balance  sheets  reflect  tax  rather  than  actual  conditions. 
Auditors  do  not  oppose  the  change,  provided  the  facts  are  clearly 
shown  in  the  balance  sheet,  because  balance  sheets  on  such  a 
basis  are  most  conservatively  stated. 

Export  Sales 

When  sales  of  goods  to  be  exported  are  paid  for  in  advance,  or 
at  time  of  shipment,  no  question  arises  as  to  the  period  in  which 
the  profit  should  be  taken.  When  goods  are  shipped  to  foreign 
customers  against  open  drafts,  it  may  be  inadvisable  to  anticipate 
the  profit,  because  it  frequently  happens  that  drafts  are  not  hon- 
ored and  the  goods  must  be  resold. 

There  can  be  no  fixed  rule  which  will  cover  all  cases.  Good 
accounting  practice  permits  one  of  two  methods : 

1.  When  the  goods  are  not  paid  for  in  cash,  and  if  there  is 

some  doubt  that  the  goods  will  be  paid  for,  the  export 
concerns  may  carry  the  goods  as  part  of  their  inven- 
tories priced  at  their  actual  value  on  the  spot  where 
they  happen  to  be. 

2.  When  there  is  little  doubt  about  the  collection  of  the  pro- 

ceeds of  the  drafts  and  ample  reserves  are  created  for 
doubtful  accounts,  such  shipments  may  be  treated  as 
sales  and  the  uncollected  proceeds  may  be  treated  as 
accounts  receivable  at  their  net  value. 

Accounts  Collectible  in  Foreign  Currency. — The  fluc- 
tuation of  foreign  exchange  rates  and  their  depression  below  ''par  " 
introduces  uncertain  features  into  the  valuation  of  foreign  accounts. 

These  conditions  arise  principally  under  the  following  cir- 
cumstances: 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  105 

1.  When  accounts  receivable  or  payable  are  to  be  settled  in 

terms  of  foreign  money. 

2.  When  foreign  business  is  conducted  through  branches 

located  abroad  or  through  foreign  subsidiary  corpora- 
tions. 

The  United  States  Treasury  Department  has  approved,  under 
certain  prescribed  conditions,  the  deduction  of  exchange  losses 
from  taxable  income.  The  correct  accounting  treatment  of  such 
losses,  therefore,  becomes  a  prerequisite  to  the  determination  of 
proper  income  and  profits  tax  liability. 

Determining  the  value  of  foreign  accounts  receivable  to 
be  settled  in  terms  of  United  States  money  embraces  no 
problems  arising  out  of  the  exchange  situation.  When 
transactions  are  to  be  settled  in  terms  of  foreign  money,  the 
accounts  should  also  be  kept  in  the  money  terms  of  the  foreign 
country. 

The  open  items  in  a  foreign  account  should  be  identified  and 
the  differences  between  the  dollar  value  at  the  exchange  rates 
prevailing  on  the  date  of  the  origin  of  the  transaction,  and  the 
dollar  value  of  the  foreign  money  received  or  paid  as  of  the  date 
of  the  settlement  on  the  closed  transactions  which  represent 
exchange  losses  or  gains,  should  be  transferred  to  an  income 
account.  The  accounts  which  remain  unsettled  at  the  date 
of  audit  should  be  valued  at  the  current  exchange  rates  on  the 
closing  date. 

If  the  foreign  activities  consist  entirely  of  trading,  and  the 
foreign  assets  and  liabilities  are  all  of  a  current  nature,  the  con- 
version of  their  value  into  terms  of  United  States  currency  would 
be  made  at  the  prevailing  exchange  rates. 

If  the  foreign  activities  include  both  manufacturing  and  trad- 
ing, and  the  assets  include,  in  addition  to  current  items,  fixed 
investments  in  the  form  of  plant  and  equipment,  these  fixed  as- 
sets should  receive  further  consideration.^ 


<5  For  further  discussion  of  this  subject,  see  under  "branch  accounts," 
page  67. 


I06  AUDITING— GENERAL  PRINCIPLES 

Deposits 

Another  class  of  items  sometimes  included  in  the  current  as- 
sets is  cash  deposits  put  up  as  security  under  a  lease  for  the  faith- 
ful performance  of  a  contract;  as  security  for  costs,  etc.,  in  an 
appeal  to  a  higher  court;  by  agents  who  have  ordered  goods  in 
advance,  such  as  automobiles;  with  public  utility  companies,  etc. 

In  these  and  many  other  cases,  the  proprietors  of  a  going 
business  feel  that  the  cash  so  paid  out  is  a  good  asset.  Frequently 
they  either  count  on  getting  back  the  cash  itself  or  they  know  that 
the  deposits  will  be  applied  on  purchases.  When  deposits  are 
known  to  be  repayable  within  a  short  time  or  on  demand  the  items 
should  be  included  in  current  assets. 

In  the  case  of  leases,  etc.,  the  cash  may  be  returned,  but  the 
period  of  realization  is  most  uncertain  and  cannot  be  depended 
upon  as  a  source  of  funds  available  for  other  purposes  than  the 
special  one  for  which  the  deposit  was  made.  The  landlord  who 
holds  a  cash  deposit  as  security  under  a  lease  will  probably  re- 
quire the  same  or  a  larger  amount  upon  renewal.  In  many  long 
leases  the  deposit  is  to  apply  on  the  last  year's  rent.  If  there  is 
no  renewal,  the  landlord  may  hold  deposits  for  several  years 
pending  the  settlement  of  a  claim  for  injury  to  the  premises. 

In  the  case  of  advances  it  is  true  that  the  deposits  will  be 
applied  on  purchase  contracts,  but  this  is  in  effect  a  prepay- 
ment and  no  cash  will  be  returned  which  can  be  paid  to  other 
creditors. 

For  all  practical  purposes,  therefore,  these  items  are  a  part  of 
the  fixed  or  deferred  assets  and  furnish  very  poor  security  for 
unsecured  creditors. 

Verification  of  Outstandings  by  Correspondence 

There  is  but  one  absolute  method  of  ascertaining  the  accuracy 
of  the  aggregates  shown  on  the  balance  sheet  as  due  from  trade 
and  other  debtors.  This  is  to  procure  an  acknowledgment  of  the 
debt  from  the  debtor.  This  is  impracticable  in  most  cases,  but 
wherever  the  opportunity  exists  the  auditor  should  verify  the 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  107 

correctness  of  the  outstandings  by  requesting  confirmations  by 
direct  correspondence  with  the  debtors. 

This  subject  is  discussed  more  fully  on  page  525. 

Notes  Receivable 

This  account  should  include  only  unmatured  notes  free  from 
Hens.  Notes  on  hand  should  be  examined  as  to  amounts,  maturi- 
ties, signatures,  and  indorsements.  As  a  rule  the  dates  and  the 
places  where  payable  are  not  important  to  an  auditor.  All  notes 
receivable  should  be  examined  at  the  same  time  in  order  to  pre- 
vent substitution.  Notes  out  for  collection  should  be  Hsted  and 
confirmed. 

In  most  respects  the  valuation  of  notes  receivable  should  be 
made  along  the  lines  indicated  for  accounts  receivable.  In  some 
trades  notes  are  given  by  concerns  of  the  very  highest  standing, 
as,  for  instance,  in  the  silk  and  jewelry  trades.  In  other  lines, 
such  as  the  automobile  and  grocery  trades,  notes  are  consid- 
ered a  sign  of  weakness.  The  first  consideration,  therefore, 
must  be  as  to  the  custom  of  the  particular  business  under  re- 
view. If  it  is  usual  to  accept  notes  from  first-class  debtors,  the 
notes  are  valued  in  the  same  manner  as  book  accounts.  (See 
page  91.) 

If  notes  have  been  accepted  from  other  than  trade  debtors, 
or  if  it  is  not  the  general  custom  of  the  trade  to  give  notes,  then 
each  individual  note  must  be  valued  on  its  merits.  The  examina- 
tion should,  of  course,  cover  notes  under  discount  as  well  as  those 
on  hand.  The  former  should  be  verified  by  correspondence  with 
the  bankers,  or  by  inspection  of  the  discount  records.  Inspection, 
however,  must  not  be  confined  to  an  examination  and  listing  of 
notes  on  hand,  because  part  thereof  may  have  been  paid;  or,  if 
overdue  and  still  carried  in  the  notes  receivable  account,  they 
may  have  been  charged  back  to  the  makers'  individual  accounts. 
Care  should  be  taken,  therefore,  to  reconcile  each  note  compris- 
ing part  of  the  notes  receivable  ledger  account  with  the  notes 
themselves,  or  other  satisfactory  records. 


I08  AUDITING— GENERAL  PRINCIPLES 

An  effort  should  be  made  to  ascertain  whether  any  notes  repre- 
sent renewals,  and,  if  so,  the  original  dates  should  be  noted. 

Demand  notes  and  all  others  upon  which  partial  payments 
may  have  been  made  should,  when  feasible,  be  verified  by  corre- 
spondence. The  auditor  is  charged  with  knowledge  that  partial 
payments  are  frequently  made  and  care  is  not  always  taken  to 
indorse  such  payments  on  the  notes. 

If  notes  are  not  paid  at  maturity,  they  should,  as  stated,  be 
taken  out  of  the  notes  receivable  account,  since  the  latter  account 
should  represent  unmatured  notes  only.  It  may  be  feasible  to 
carry  dishonored  notes  in  a  separate  account,  but  it  is  proper 
accounting  practice  to  debit  the  personal  account  of  the  debtor 
with  the  amount  of  the  note  and  the  protest  fees  and  to  include 
the  debt  among  those  of  the  class  to  which  it  belonged  before  it 
was  converted  from  an  account  receivable  into  a  note  receivable. 

Thus,  if  a  grocer  sells  sugar  to  a  customer,  takes  a  note  for  the 
amount  of  the  sale,  is  unable  to  collect  when  due  and  therefore 
charges  the  note  and  protest  fees  back  to  the  customer's  account, 
he  should  include  the  new  balance  among  his  trade  debtors.  The 
auditor,  in  valuing  the  accounts,  should  estimate  the  worth  of  this 
account  taking  into  consideration  the  facts  as  shown  on  its  face. 

Protested  notes  are  frequently  paid  thereafter,  but  they  can- 
not be  classed  with  accounts  not  due,  or  with  those  overdue  from 
chronically  slow  payers.  The  maker  of  a  note  who  fails  to  meet 
his  obHgation  at  maturity  is  never  a  desirable  customer,  and  sub- 
sequent credit  extended  to  such  customers  invites  ultimate  loss. 

There  are  exceptions  to  this  rule  in  the  case  of  such  concerns 
as  agricultural  implement  manufacturers  with  whom  it  is  the 
custom  to  take  notes  for  a  large  part  of  sales.  Many  are  not  paid 
during  years  of  crop  failures.  These  overdue  notes  are  considered 
almost  as  collectible  (so  far  as  ultimate  reahzation  is  concerned) 
as  the  unmatured  ones,  and,  since  it  is  more  convenient  for  the 
collection  department  to  handle  them  as  notes  than  as  part  of 
open  accounts,  they  are  not  charged  back  to  the  customers' 
accounts.     Under  such  circimistances,  when  stating  the  item 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  109 

"notes  receivable"  in  the  balance  sheet,  the  auditor  may  not 
consider  it  necessary  to  separate  the  overdue  and  not  due  notes, 
but  he  should  be  sure  that  one  class  is  as  good  as  the  other,  or 
that  a  sufficient  reserve  has  been  created  for  the  probable  loss. 

Trade  acceptances  should  not  be  confused  with  notes  receiv- 
able.   They  should  appear  as  a  separate  item  in  the  balance  sheet. 

Notes  Receivable  Discounted — The  balance  sheet  should 
show  the  notes  or  acceptances  under  discount  because  a  con- 
tingent Habihty  thereon  exists.  They  are  hypothecated  assets 
against  which  a  loan  has  been  secured  from  the  bank,  therefore 
the  aggregate  under  discount  should  be  shown  in  the  balance 
sheet. 

Formerly  when  notes  receivable  from  good  customers  were 
discoimted,  the  merchant  or  manufacturer  was  inclined  to  look 
upon  this  transaction  as,  in  effect,  the  sale  of  an  asset,  which  was 
thus  removed  from  further  consideration  so  far  as  the  financial 
statement  was  concerned.  In  other  words,  he  considered  that  he 
parted  with  his  ownership  of  the  item  to  the  bank  and  looked  to 
the  bank  to  collect  from  the  customer.  It  is  true  that  the  dis- 
counter of  the  note  was  required  to  indorse  it,  but  the  contingent 
liability  existing  because  of  the  responsibility  of  the  indorser  for 
payment  to  the  bank,  if  the  maker  of  the  note  defaulted,  was  not 
considered  of  sufficient  importance  to  make  it  necessary  to  refer 
to  it  on  the  balance  sheet. 

Such  an  attitude  might  have  some  justification  if  practically 
all  discounted  notes  were  paid  promptly  at  maturity,  but  of 
course,  this  is  not  the  case.  It  is  almost  needless  to  say  that  the 
attitude  of  auditors  has  changed  radically  as  respects  reference  to 
notes  receivable  discounted;  in  fact  it  is  no  longer  discretionary 
to  omit  reference  to  them  in  the  balance  sheet. 

It  has  been  claimed  that  the  proper  method  is  to  show  the 
amount  under  discount  on  both  sides  of  the  balance  sheet,  since 
they  are  in  a  very  real  sense  assets  hypothecated  with  the  bank  as 
security  for  loan  from  it.    It  is  not  the  general  custom,  however. 


no  AUDITING— GENERAL  PRINCIPLES 

to  state  the  aggregate  amount  on  both  sides  of  the  balance  sheet, 
but,  if  it  is  not  set  forth  in  this  manner,  then  it  is  obhgatory  that 
a  note  shall  be  made  on  the  balance  sheet,  preferably  under  the 
liabihty  section,  to  the  effect  that  a  certain  amount  of  notes  or 
acceptances  not  yet  matured  are  under  discount  and  that  a  con- 
tingent liabihty  exists  in  respect  thereof  until  they  are  paid  by 
the  makers. 

Instances  are  known  of  notes  for  large  sums,  but  with  makers 
of  little  responsibility,  which  have  been  discounted  and  renewed 
as  long  as  the  banks  would  take  them.  If  the  facts  are  not  known 
and  if  several  bank  accounts  are  kept,  it  is  easy  to  shift  discounts 
from  one  bank  to  another.  Obviously  such  notes  are  in  reality 
notes  payable.  The  auditor  is  not  justified  in  certifying  to  the 
balance  sheet  item  of  notes  receivable  unless  he  believes  that  all 
of  the  notes  will  be  paid  when  due,  or  unless  a  sufficient  reserve 
is  created  to  cover  probable  losses  in  realization. 

Accrued  Interest  Receivable 

This  item  represents  amounts  accrued  on  notes,  bonds,  and 
other  investments.  If  the  interest  is  due  from  solvent  debtors 
who  have  not  defaulted  on  any  previous  instalments  and  if  it  is 
due  within  a  few  months  of  the  date  of  the  balance  sheet,  there  is 
no  objection  to  including  it  among  the  current  assets. 

Stock  Subscriptions 

The  uncollected  balances  due  from  stockholders  on  their  sub- 
scriptions to  the  capital  stock  of  a  corporation  are  undoubtedly 
accounts  receivable,  but  it  is  not  considered  proper  to  include 
such  balances  with  the  receivables  of  any  other  class.'  The  reason 
for  this  is  obvious.  If  the  subscriptions  are  overdue,  the  fact  of 
their  non-collection  indicates  either  poor  management  or  unde- 
sirable stockholders.  If  not  due,  it  affords  those  who  use  the 
balance  sheet  an  opportunity  to  inquire  into  the  financial  standing 
of  the  debtors.  If  good,  it  not  only  means  that  a  certain  amount 
of  liquid  capital  will  be  forthcoming  at  a  certain  date,  but  it  also 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  HI 

furnishes  evidence  that  the  capital  stock  is  being  paid  for  in  cash, 
and  is  reassuring  as  to  the  future,  because  the  connection  of  finan- 
cially responsible  stockholders  with  a  company  usually  means 
that  they  are  prepared  to  stand  by  it  and  protect  their  interests. 
If  surely  collectible  within  one  year  the  item  may  be  included 
among  the  current  assets. 

Investment  Securities 

As  we  are  now  discussing  current  or  quick  assets,  it  must  be 
understood  that  the  term  '' investment  securities"  does  not  in- 
clude securities  the  sale  of  which  would  affect  the  normal  opera- 
tion of  a  business. 

If  stocks  or  bonds  represent  control,  or  a  material  interest,  in 
other  enterprises,  the  ownership  of  which  is  more  or  less  valuable 
to  the  holder  outside  of  the  direct  return  thereon,  they  should  be 
designated  as  fixed,  not  as  current,  assets. 

Securities  as  Stock-in-Trade 

Where  the  purchase  and  sale  of  securities  is  part  of  the  regular 
business  of  the  firm  or  corporation,  an  inventory  should  be  taken 
the  same  as  is  done  with  the  stock-in-trade  of  other  concerns. 

It  is  usually  easier  to  ascertain  market  values  of  securities 
than  of  other  inventories,  but  greater  care  must  be  taken  with 
the  individual  items.  The  rule,  cost  or  market,  whichever  is 
lower,  should  govern  each  item,  rather  than  the  aggregate.  Under 
normal  conditions  and  when  conservatism  is  desired,  the  rule  is 
a  good  one  and  applies  better  than  in  case  of  merchandise  inven- 
tories. 

If  it  is  important  to  have  the  balance  sheet  reflect  actual 
values,  any  security  which  has  depreciated  in  value  should  be 
written  down  to  the  market;  an  apparent  rise  in  value  may  be 
taken  advantage  of  when  the  securities  are  in  active  demand  and 
if  the  market  continues  in  an  equally  satisfactory  condition  after 
the  date  of  the  balance  sheet  and  up  to  the  time  of  the  report. 

It  frequently  happens  that  a  few  sales  of  an  inactive  security 


112  AUDITING— GENERAL  PRINCIPLES 

may  appear  to  fix  a  higher  or  lower  valuation  than  that  at  which 
it  is  carried,  but  these  sales  and  quotations  are  exceedingly  un- 
certain. The  auditor,  in  pricing  securities,  must  be  sure  of  his 
evidence. 

The  securities  must  be  examined  by  the  auditor  in  person  or 
else  he  must  secure  confirmations  of  their  existence  from  those 
who  hold  them.  It  is  needless  to  say  that  the  securities  should  be 
counted  as  soon  as  possible  after  the  audit  is  begun,  and  that  all 
should  be  submitted  to  the  auditor  at  one  time.  If  this  is  not 
practicable,  the  auditor  should  place  one  of  his  assistants  in  a  posi- 
tion where  all  changes  between  the  commencement  of  the  audit  and 
the  completion  of  the  verification  of  the  securities  can  be  noted. 

Certificates  taken  out  for  transfer  should  be  verified  by  corre- 
spondence. 

As  coupons  due  at  future  dates  may  be  detached  and  sold,  the 
careful  auditor  will  note  whether  bonds  have  all  of  their  un- 
matured coupons  attached.  This  is  not  usually  done  in  concerns 
where  bonds  are  frequently  handled  by  different  persons;  in  other 
cases  it  is  a  wise  precaution.  Where  investments  are  supposed  to 
remain  unchanged,  it  is  suggested  that  the  auditor  note  the  serial 
numbers  of  a  few  representative  stocks  and  bonds,  and  check 
these  numbers  on  subsequent  visits.  Instances  are  known  in 
which  securities  have  been  sold  immediately  after  an  audit  but 
were  replaced  before  the  commencement  of  another  audit. 

A  director  of  a  bank  told  the  author  that  in  examining  securi- 
ties the  same  lot  of  bonds  had  been  handed  to  him  four  or  five 
times  at  each  examination  during  a  period  of  some  years.  If 
ordinary  precautions  had  been  taken  and  all  the  securities  ordered 
into  the  directors'  room  at  one  time — a  feasible  and  simple  plan 
in  this  instance — a  large  defalcation  would  have  been  prevented 
or  discovered  at  an  early  stage. 

Liberty  Bond  Valuations 

Due  to  purely  patriotic  motives,  corporations  and  individuals 
during  191 7  and  19 18  purchased  billions  of  dollars  worth  of  United 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  II3 

States  Liberty  bonds  at  par.  When  the  last  issue  was  offered  it 
was  known  that,  owing  to  the  low  rate  of  interest,  the  bonds 
would  not  remain  at  par;  nevertheless  the  entire  issue  was  sold  at 
par.  There  has  never  been  any  question  about  the  safety  of  the 
principal,  but  during  a  period  of  high  money  rates  it  cannot  be 
expected  that  low  interest  rate  bonds  will  sell  at  par,  no  matter 
how  well  secured  the  principal  may  be.  At  various  times  plans 
have  been  offered  in  Congress  and  elsewhere  to  insure  government 
bonds  selling  at  par  at  all  times.  One  suggestion  is  to  refund  the 
entire  debt  into  one  issue  and  have  the  interest  rate  adjusted  each 
six  months  so  that  the  bonds  will  always  sell  at  par. 

In  view  of  the  fluctuations  of  the  market  and  the  uncertainty 
regarding  plans  to  pay  a  fair  rate  of  interest,  most  concerns  which 
own  Liberty  bonds  have  carried  them  in  their  balance  sheets  at 
par.  The  author  examined  a  large  number  of  balance  sheets  and 
found  this  to  be  the  case.  Strangely  enough,  some  banks,  includ- 
ing the  federal  reserve  banks,  the  officers  of  which  importuned 
their  customers  almost  to  the  point  of  duress  to  buy  the  bonds  at 
par,  have  been  the  first  ones  to  criticize  the  practice  of  carrying 
the  bonds  at  par.  On  the  other  hand,  when  taxpayers  have 
written  off  accrued  losses,  the  Treasury  has  refused  to  sanction 
the  marking  down  from  par  to  market,  consequently  it  may  be 
regarded  as  good  accoimting  practice  to  carry  Liberty  bonds  at 
par.  It  is  necessary,  however,  that  the  words  '^at  cost"  should 
appear  in  the  balance  sheet,  because  all  Liberty  bonds  sell  at  a 
discount  and,  if  no  explanation  is  added,  it  might  be  assumed 
that  they  are  valued  at  market  prices.  It  usually  is  advisable  to 
note  on  balance  sheets  the  market  price  when  the  difference  be- 
tween book  value  and  cost  is  substantial. 

Insurance  on  Lives  of  Proprietors 

Many  concerns  insure  the  Hves  of  officers,  executives,  or  part- 
ners for  the  benefit  of  the  business,  the  premiums  being  paid  by 
the  concern.  The  amoimt  carried  in  the  balance  sheet  for  this 
item  should  be  the  cash  surrender  value  of  the  pohcy.     The 

VOL.  1—8 


114  AUDITING— GENERAL  PRINCIPLES 

difference  between  the  annual  increase  in  this  value  and  the 
amount  of  the  annual  premiums  paid  should  be  charged  to  in- 
come. In  view  of  the  cash  value  of  this  item  it  may  be  classed 
as  a  current  asset,  unless  excluded  by  express  terms  in  an  agree- 
ment with  creditors. 

Temporary  Investments 

Considerable  publicity  has  been  given  in  recent  years  to  the 
desirability  of  trading  and  manufacturing  concerns  purchasing 
and  carrying  a  reasonable  line  of  marketable  securities  to  provide 
for  unforeseen  contingencies,  or  for  extensions  of  the  business  or 
other  extraordinary  needs  which  require  funds  on  short  notice. 

The  theory  is  that  many  businesses  which  have  expanded 
rapidly,  and  which  are  apparently  prosperous,  invest  all  of  their 
available  capital  and  surplus  in  extensions  of  their  plant,  etc., 
and  that  a  sudden  call  for  cash  finds  them  in  a  vulnerable  position. 
This  argument  is  sound  enough  from  a  conservative  point  of 
view,  but  it  may  be  urged  that  the  merchant  who  is  too  conserva- 
tive never  buys  for  fear  that  he  cannot  sell,  and  that  he  may  as 
well  invest  his  surplus  earnings  in  his  own  business  and  thus  earn 
a  much  higher  return  than  can  be  reaHzed  from  securities. 

These  investment  securities,  to  fulfil  their  function  properly, 
should  be  on  hand  (not  hypothecated)  and  should  be  presented  to 
the  auditor  for  his  inspection. 

As  the  whole  theory  of  these  security  holdings  rests  on  their 
availabiUty,  they  should  be  priced  at  their  fair  market  valuation 
as  of  the  balance  sheet  date,  irrespective  of  cost.  Otherwise,  they 
cannot  be  considered  as  the  equivalent  of  cash.  This,  however, 
is  not  a  hard-and-fast  rule.  If  the  variations  in  market  prices  are 
slight  and  the  tendency  is  upward,  no  adjustment  in  values  need 
be  made.  If  the  tendency  is  downward,  the  auditor  should  insist 
on  a  revaluation  unless  the  variation  is  so  small  that  the  difference 
is  trifling. 

A  further  test  of  the  availability  of  this  class  of  securities  is  the 
existence  of  a  firm  market  and  stable  quotations.    If  not  listed  on 


BALANCE  SHEET  AUDIT— CURRENT  ASSETS  115 

the  stock  exchange  the  bankers  who  make  a  specialty  of  the  par- 
ticular issues  should  be  asked  for  a  ''bid-and-asked"  quotation 
as  of  the  date  of  the  balance  sheet. 

Postage  and  Other  Stamps 

In  most  audits  this  item  is  unimportant,  but  in  some  classes 
of  business  the  stamps  on  hand  are  sufhciently  large  to  require 
attention.  This  is  particularly  true  of  mail-order  houses  and  of 
stock-brokers,  who  usually  carry  large  quantities  of  transfer 
stamps. 

The  principal  reason  for  presenting  the  matter  here  is  that  it 
gives  an  auditor  an  opportunity  to  inquire  about  the  stock  of 
stamps  on  hand  and  to  look  into  the  method  of  handling  them. 
So  much  carelessness  exists  in  this  matter  that  it  is  well  worth 
investigating. 

Deferred  Charges  to  Operation — Prepaid  Items 

In  nearly  all  balance  sheets  items  appear  which  can  be  classi- 
fied under  this  caption,  although  in  many  cases  where  there  are 
only  one  or  two  accounts,  such  as  prepaid  insurance,  rents,  etc., 
there  is  no  grouping,  but  the  items  are  stated  in  detail.  Some 
deferred  charges  to  operation  are  properly  included  as  current 
assets  and  some  are  not.  Good  accounting  practice  permits  the 
inclusion  among  current  assets  of  all  prepaid  items,  such  as  pre- 
paid rent,  insurance,  interest,  taxes,  royalties,  and  all  other  items 
which  are  chargeable  to  current  operations  or  expenses  and  which 
as  a  part  of  the  current  and  necessary  cost  of  conducting  a  busi- 
ness may  reasonably  be  expected  to  be  reimbursed  to  the  business. 
The  reimbursement  must  be  as  probable  as  the  realizations 
through  sales  of  raw  materials  and  other  operating  costs.  In  the 
opinion  of  the  author  it  is  improper  to  class  as  current  assets 
accounts  or  notes  receivable  which  do  not  mature  within  a  year, 
and  stock-in-trade  which  cannot  reasonably  be  sold  within  a  year, 
except  in  those  industries  in  which  long-time  realizations  of 
^'  current  assets  "  are  recognized  as  usual  and  proper.    Under  the 


Il6  AUDITING— GENERAL  PRINCIPLES 

same  principle,  prepaid  items  which  are  not  properly  chargeable 
to  current  operations  within  a  year  are  not  current  assets.  De- 
posits under  ten-year  leases,  which  are  to  be  applied  to  the  rental 
for  the  last  year  of  the  lease,  are  not  current  assets  during  the 
first  nine  years.  Prepaid  discount  on  a  four  or  six  months'  bank 
loan  is  a  current  asset,  but  prepaid  discount  on  a  long-term  bond 
issue  is  not  a  current  asset.  Perhaps  the  discount  for  one  year 
might  be  deemed  to  be  a  current  asset,  but  the  point  is  rather  too 
fine  to  be  good  practice.  Current  advertising,  seasonal  catalogs, 
and  similar  advance  expenditures  to  be  used  in  the  immediate 
future  as  part  of  the  usual  operations  of  the  business,  are  current 
assets,  but  special  expenditures  for  advertising  and  exploitation 
are  not  current  assets. 

The  items  to  be  classed  as  current  assets  depend  on  circum- 
stances. There  is  no  inflexible  rule  and  the  auditor  must  use  his 
judgment.  In  all  cases,  however,  the  general  principle  under- 
lying the  term  ''current  assets"  must  be  adhered  to,  viz.,  ''cur- 
rent assets  consist  solely  of  those  which  are  the  equivalent  of 
cash  or  which  through  the  normal  operations  of  the  business  will 
be  converted  directly  or  indirectly  into  cash  within  one  year  from 
the  date  of  the  balance  sheet." 

The  auditor  cannot  verify  the  accuracy  of  the  book  figures 
unless  an  analysis  is  made  of  the  charges  to  the  various  accounts. 
As  this  subject  is  discussed  fully  in  the  chapter  on  the  detailed 
audit  (page  569  et  seq.),  no  further  comment  is  required  here. 


CHAPTER   VIII 
INVENTORIES— GENERAL   PRINCIPLES 

Inventory  valuations  present  few  problems  of  principle  when 
times  are  normal;  but  times  have  not  been  normal  since  1916  and 
cannot  be  normal  until  a  considerable  period  elapses  after  192 1. 
Times  are  not  normal  when  goods  sell  at  less  than  cost  nor  when 
prices  are  inflated. 

Until  times  become  normal  again,  it  is  imperative  that  special 
consideration  be  given  to  the  principles  which  underlie  balance 
sheet  valuations  and  the  relation  of  the  inventory  to  the  other 
items  in  the  balance  sheet.  It  will  be  necessary  to  compare  good 
accounting  practice  with  expediency,  and  to  discuss  the  various 
methods  of  arriving  at  "cost"  and  at  ''value." 

Introductory 

Of  all  items  shown  in  the  balance  sheet  the  inventory  is  most 
difficult  to  verify.  Cash  and  accounts  receivable  present  rela- 
tively few  problems;  plant  valuation  and  depreciation  are  more 
uncertain  from  the  point  of  view  of  ultimate  realization,  but  that 
uncertainty  in  a  great  measure  relieves  the  auditor  from  most  of 
the  responsibility  attached  to  plant  valuations;  liabilities  are 
determined  with  comparative  ease,  but  it  is  not  satisfactory  to 
qualify  the  inventory  item  in  the  balance  sheet  to  the  point  of 
obscuring  its  known  value.  Those  who  rely  on  balance  sheets 
want  something  more  than  the  statement,  "cost  or  market, 
whichever  is  lower,"  whenever  apparent  market  values  vary 
substantially  from  cost. 

Effects  of  Price  Changes. — During  the  past  few  years 
market  values  have  fluctuated  so  greatly  that  there  has  been  no 

117 


Il8  AUDITING— GENERAL  PRINCIPLES 

uniform  valuation  even  of  basic  commodities,  for  which  close  and 
apparently  trustworthy  quotations  are  usually  available;  more- 
over, when  reference  was  made  to  many  of  the  published  quota- 
tions the  answer  was  frequently  made,  "There  is  no  business 
being  done  at  those  figures."  At  the  close  of  the  years  191 7  and 
19 1 8,  quoted  market  prices  were  in  most  cases  in  excess  of  cost; 
"cost"  in  turn  was  often  deemed  to  be  excessive  and  temporary, 
so  that  many  inventories  were  priced  for  balance  sheet  purposes 
on  a  basis  which  was  less  than  either  cost  or  apparent  market. 
Auditors  met  this  situation  by  stating  in  balance  sheets  that  in- 
ventories were  taken  at  "cost  or  less/'  thus  meeting  the  require- 
ments of  those  who  demand  that  balance  sheets  show  inventories 
priced  on  a  conservative  basis.  This  was  the  first  apparent  de- 
parture from  the  rule,  ''cost  or  market,  whichever  is  lower "^  it 
was  not  an  actual  departure — the  apparent  departure  lay  in  an 
erroneous  interpretation  of  the  word  "market." 

The  net  result  of  violent  price  fluctuations  and  of  profits  taxes 
and  other  war  conditions  has  been  an  almost  complete  upsetting 
of  uniformity  of  procedure  in  the  valuation  of  inventories.  In- 
evitably there  came  a  complete  reversal  of  the  1917  and  1918  con- 
ditions, and^  generally  speaking,  at  the  end  of  1919  everybody 
wished  to  disregard  "cost  or  market,  whichever  is  lower"  and  to 
use  still  lower  prices,  arguing  (correctly  as  it  turned  out)  that  the 
cycle  of  inflation  was  on  its  last  lap.  At  the  end  of  1920  also, 
there  was  manifest  a  desire  to  ignore  the  rule.  *'  cost  or  market, 
whichever  is  lower,"  for  many  inventories  were  valued  at  cost  or 
market,  whichever  was  higher,  while  in  some  cases  a  middle 
ground  was  selected. 

It  is  claimed  that  this  condition  is  temporary,  but  the  up- 
turn from  1916  to  1920  and  the  downward  trend  from  1920  mark 
aperiod  of  atleast  six  years.  If  at  the  end  of  192 1  many  commodi- 
ties are  no  longer  selling  in  quantities  below  the  cost  of  produc- 
tion, it  may  be  that  there  is  a  commencement  of  a  normal  period. 
One  year,  however,  cannot  be  called  a  normal  period,  so  that  we 
find  it  necessary  to  discuss  conditions  which  have  existed  for 


INVENTORIES— GENERAL  PRINCIPLES  II9 

some  years  and  which  remain  largely  unchanged  at  the  end  of 
1921. 

Accounting  for  Fluctuating  Inventory  Values. — When 
there  are  no  substantial  changes  in  costs  or  sales  prices,  invento- 
ries are  properly  valued  at  cost.  The  income  accounts  of  the  pre- 
ceding and  succeeding  periods  are  not  affected  by  the  quantity  of 
unsold  goods,  and  the  balance  sheet  reflects  current  values.  When 
there  are  substantial  variations  in  costs  or  sales  prices,  the  carry- 
ing forward  of  inventories  at  cost  may  misstate  the  income  ac- 
count of  two  periods,  and  the  balance  sheet  is  equally  misleading 
if  it  shows  the  inventory  at  cost  when  the  market  is  substantially 
above  cost;  or  at  *' market"  when  the  apparent  market  is  much 
below  cost  although  the  actual  market  may  not  be  as  low  as 
nominal  quotations  may  indicate. 

When  there  is  a  change  in  partnership  interests  there  should 
be  a  new  balance  sheet  reflecting  actual  rather  than  book  values; 
the  most  important  changes  usually  are  in  the  inventories.  A 
new  partner  is  not  willing  to  buy  into  a  concern  which  carries  its 
inventories  at  cost  when  they  can  be  replaced  below  cost,  and  a 
retiring  partner  is  unwilling  to  sell  goods  at  cost  which  are  defi- 
nitely worth  more.  There  are  frequent  changes  in  the  ownership 
of  corporations  but,  owing  to  the  form  of  organization,  it  is  not 
usual  to  adjust  the  accounts  when  stock  holdings  change.  The 
author  is  of  the  opinion  that  it  is  due  to  stockholders  to  present 
to  them  balance  sheets  which  are  as  nearly  correct  as  possible; 
but  balance  sheets  cannot  be  relied  upon  if  radical  changes  in  the 
values  of  current  assets  are  ignored. 

The  usual  arguments  against  revaluations  of  inventories  are 
these:  When  market  values  are  less  than  cost,  writing  down  to 
market  value-  may  show  an  apparent  profit  in  the  succeeding 
period  if  market  prices  rise  above  the  inventory  value,  even 
though  cost  price  is  not  realized,  or  the  executives  may  be  misled 
by  the  adjusted  low  book  values  and  fix  unnecessarily  low  sales 
prices.    When  market  values  are  above  cost,  the  taking  up  of  the 


120  AUDITING— GENERAL  PRINCIPLES 

appreciation  is  anticipating  profits  which  have  not  been  realizedo 
Fortunately  the  solution  of  the  difficulties  is  comparatively 
simple;  there  has  never  been  any  objection  to  noting  in  balance 
sheets  market  values  when  they  were  greater  or  less  than  balance 
sheet  or  book  values.  The  author  suggests  a  method  which  does 
not  interfere  with  the  accounting  for  original  costs,  when  market 
prices  are  going  down,  and  which  sets  up,  but  does  not  carry 
into  earned  surplus,  appreciation  in  values  when  market  prices 
are  rising.  It  is  suggested  that  the  differences  between  cost  and 
market  prices  be  carried  into  reserve  accounts  which  should 
remain  open  until  the  inventories  are  finally  disposed  of.  Re- 
serves for  appreciation  in  market  prices  set  up  on  balance  sheets 
should  be  clearly  designated  as  representing  a  contingent  and 
imcertain  asset;  reserves  for  declines  in  value  should  appear  on 
the  books  of  account,  but  good  accounting  practice  does  not  re- 
quire segregation  on  balance  sheets  if  inventories  are  shown  as 
being  valued  at  market  when  market  is  less  than  cost.' 

Relativity  of  Balance  Sheet  Values. — The  word  ^'rela- 
tivity" is  not  often  used  in  referring  to  balance  sheets,  neverthe- 
less it  should  have  its  place  in  accountancy  terminology.  Inven- 
tories of  goods  which  are  to  be  shipped  immediately  after  the  date 
of  the  balance  sheet,  are  often  priced  far  below  their  actual  values. 
Accounts  receivable  too  recent  to  question,  and  notes  receivable 
maturing  over  a  period  of  years,  are  honestly  assumed  to  be  the 
equivalent  of  cash  and  are  often  priced  far  above  the  actual 
values.  In  192 1  a  very  large  concern  was  liquidated  by  creditors 
because  of  its  inability  to  collect  many  millions  of  dollars  in 
outstanding  accounts  receivable.  At  the  time  the  accounts  were 
created  and  for  some  time  thereafter  they  were  all  believed  to  be 
good.  One  of  the  bankers  who  investigated  the  cause  of  the  fail- 
ure said:  *'The  trouble  with  the  business  was  that  good  furs 
were  exchanged  for  poor  receivables."    The  inference  is  obvious. 


^  For  a  discussion  of  this  point  and  forms  of  journal  entries,  see  article  by 
R.  E.  Booth  in  Administration  for  July,  192 1,  pages  96,  97. 


INVENTORIES— GENERAL  PRINCIPLES  \2l 

In  the  case  of  two  concerns  in  the  same  kind  of  business,  the  value 
of  the  inventory  of  one  might  be  much  more  than  the  relative 
amount  of  accoxmts  receivable  of  another.  The  relation  of  one  to 
the  other  is  a  concrete  factor  in  values  and  cannot  be  ignored.  It 
is  probable  that  if  the  furs  had  not  been  sold  the  relative  inventory 
loss  would  have  been  as  much  as  the  loss  arising  from  receivables; 
the  illustration  is  used  merely  to  support  the  argument  that  the 
values  of  accounts  receivable  are  at  times  subject  to  as  great 
fluctuations  as  the  values  of  inventories.  When  business  is  de- 
pressed, accounts  and  inventories  probably  are  worth  less  than 
face  or  market  value;  when  business  is  good,  accounts  cannot  be 
worth  more  than  face  value,  but  inventories  may  be  worth  more 
than  market  prices.  If  accounting  practice  at  one  time  ignored 
the  relative  values  of  the  two  classes  of  assets,  recent  develop- 
ments have  proved  that  hereafter  it  will  not  be  deemed  to  be  good 
accounting  practice  to  fail  to  reflect  in  a  balance  sheet  all  of  the 
elements  of  value  which  are  useful  and.  necessary  to  determine 
true  financial  condition. 

Need  of  Understandable  Rule  of  Valuation  ,^.  ^ 

The  author  no  longer  advocates  the  adoption  of  an  inflexible  )   ) 
standard  for  the  valuation  of  inventories.     Before  the  war  it 
appeared  to  be  feasible  to  follow  the  rule,  "  cost  or  market,  which-  , , 
ever  is  lower, ' '  and  great  progress  was  being  made  in  the  standard-  \ 
ization  of  that  rule  which  worked  well  in  normal  times.    The  vio-    ; 
lent  fluctuations  in  prices  due  to  the  war  largely  upset  the  rule.     ^ 
High  tax  rates  also  had  an  appreciable  effect.    It  is  foohsh  to   ,  \ 
say  that  good  accounting  principles  must  govern,  let  taxes  be     j 
what  they  may,  when  everyone  knows  that  tens  of  thousands 
of  taxpayers  have  ignored  these  so-called  good  accounting  prin- 
ciples. 

The  attempt  of  the  United  States  Treasury  to  require  that  all 
inventories  be  vahied  uniformly  at  cost  was  a  failure.  It  is  a 
misleading  and  unsound  method  of  procedure.  The  Treasury 
tried  to  enforce  its  adoption  under  heavy  penalties.    It  was  un- 


122  AUDITING— GENERAL  PRINCIPLES 

successful  and  therefore  the  effort  was  abandoned.^  The  Treas- 
ury subsequently  adopted  the  so-called  general  rule  (cost  or 
market,  whichever  is  lower). 

VALUATION  PROPOSITIONS  TO  BE  CONSIDERED 

)i  Since  many  inventories  at  the  end  of  191 7  and  1918  were 

taken  far  below  current  cost  or  market,  and  at  the  end  of  1920 
at  cost,  which  was  above  market,  and  since  the  balance  sheets 
which  included  such  valuations  were  sometimes  certified  to 
without  quahfication  by  accountants  of  unquestioned  standing, 
it  is  obvious  that  the  so-called  standard  rule  may  have  to  be 
modified  whenever  there  are  radical  variations  between  cost  and 
replacement  (market)  prices.  As  heretofore  stated,  the  author 
beHeves  that  the  rule  of  "  cost  or  market,  whichever  is  lower,"  is  a 
good  rule  and  should  set  the  standard  for  good  accounting  prac- 
tice, but  the  professional  auditor  is  sometimes  confronted  with 
conditions  which  are  not  normal.  What  attitude  shall  he  take? 
The  discussion  requires  the  consideration  of  the  following  major 
propositions : 

1 .  When  is  it  proper  to  value  an  inventory  at  less  than  either 

cost  or  market? 

2.  When  is  it  proper  to  value  an  inventory  at  ''cost  or  mar- 

ket, whichever  is  lower"? 


=•  See  Federal  Income  Tax  Procedure,  1921,  page  341.  The  latest  Treasury- 
regulation  (January,  192 1)  is  in  most  respects  satisfactory;  it  recognizes  that 
current  quotations  are  not  always  reliable,  as  quantity  is  a  vital  element. 
Article  1584  of  Regulations  45  is  as  follows: 

"Under  ordinary  circumstances,  'market'  means  the  current  bid  price 
prevailing  at  the  date  of  the  inventory  for  the  particular  merchandise  in  the 
volume  in  which  ordinarily  purchased  ....  Where  no  open  market  quota- 
tions are  available,  the  taxpayer  must  use  such  evidence  of  a  fair  market  price 
at  the  date  or  dates  nearest  the  inventory  as  may  be  available  ....  Goods 
in  process  of  manufacture  may  be  valued  for  purposes  of  the  inventory  on  the 
lowest  following  bases:  (i)  The  replacement  or  reproduction  cost  prevailing 
at  the  date  of  inventory;  or  (2)  the  proper  proportionate  part  of  the  actual 
finished  cost;  or,  under  abnormal  conditions,  (3)  the  proper  proportionate 
part  of  the  sales  price  of  the  finished  product,  account  being  taken  in  all  cases  of 
the  proportionate  part  of  the  total  cost  of  basic  elements  (materials,  labor  and 
burden)  represented  in  such  goods  in  process  of  manufacture  at  the  stages  at 
which  they  are  found  on  the  date  of  the  inventory." 


INVENTORIES— GENERAL  PRINCIPLES  I23 

3.  When  is  it  proper  to  value  an  inventory  at  reproduction 

cost  when  it  is  higher  than  replacement  cost? 

4.  When  is  it  proper  to  value  an  inventory  at  market,  market 

being  higher  than  cost? 

5.  When  is  it  proper  to  value  an  inventory  at  selling  prices? 

It  will  generally  be  admitted  that  (2)  represents  good  account- 
ing practice;  but  no  matter  how  revolutionary  it  may  seem  to  be, 
if  we  find  any  sound  arguments  for  (4)  and  if  we  find  that  it  is 
being  followed,  we  cannot  dismiss  it  on  the  ground  that  it  is 
opposed  to  good  accounting  practice.  If  any  rule  becomes  un-  - 
v/orkable  and  inapplicable,  it  becomes  necessary  to  evolve  and 
propose  a  new  rule;  and  if  the  proposed  rule  is  found  to  represent 
the  practice  of  representative  and  conservative  business  concerns 
and  of  representative  and  conservative  accountants,  then  the  new 
rule  takes  the  place  of  the  old  one  and  becomes  good  accounting 
practice.  Under  the  existing  federal  revenue  law,  the  Commis- 
sioner of  Internal  Revenue  is  required  to  follow  "  the  best  account- 
ing practice,"  consequently  there  is  no  good  reason  for  conflict 
between  tax  procedure  and  accounting  procedure.  As  Arthur 
A.  Ballantine  has  said,  ''Under  the  present  law  income  deter- 
mination is  not  so  much  a  matter  of  literal  application  of  specific 
provisions  as  a  matter  of  proper  accounting."^ 

I.  When  Is  It  Proper  to  Value  Inventories  at  Less  Than  Either 
Cost  or  Market  ? 

Before  stating  the  reasons  for  what  may  be  termed  the  under- 
statement of  inventory  values,  let  us  state  the  reasons  against  it: 

I.  Those  in  control  of  a  business  may  desire,  for  ulterior 
motives,  to  understate  its  net  worth  and  its  true  earnings  in  order  / 
to  deceive  minority  interests.  True,  this  condition  does  not  arise 
once  in  one  hundred  times,  yet  it  must  be  guarded  against. 
Therefore,  in  every  case  where  inventories  are  valued  substan- 
tially below  cost  or  apparent  market,  the  balance  sheet  should 


3  The  Federal  Income  Tax,  page  163,  Columbia  University  Lectures,  1921. 


124  AUDITING— GENERAL  PRINCIPLES 

contain  enough  information  to  guide  those  who  may  contemplate 
disposing  of  their  interests. 

2.  An  effort  may  be  made  to  understate  profits  in  order  to 
reduce  taxes  or  to  avoid  similar  expenses.  The  reduction  in  values 
below  cost  or  market  for  fraudulent  purposes  is  no  more  permis- 
sible than  is  any  other  effort  to  defraud.  It  is  reasonable  and 
proper  that  public  officers  and  others  who  are  entitled  to  audit  or 
supervise  business  affairs  should  have  available  suitable  means  of 
passing  upon  unusual  practices.  Therefore,  in  preparing  tax  or 
other  returns  in  which  the  basis  of  inventory  valuations  may  be 
an  issue,  the  basis  of  valuation  used  should  be  disclosed.  The 
burden  is  definitely  upon  the  business  concern  making  the  returns 
to  call  attention  to  any  unusual  treatment  of  inventories  which 
affects  its  tax  or  other  liability,  because  the  tax  law  requires  the 
observance  of  good  accounting  practice. 

The  following  are  reasons  why  it  is  sometimes  proper  to  value 
an  inventory  at  less  than  cost  or  apparent  market  value : 

(a)  When  market  prices  and  costs  of  production  have  in- 
creased continuously  due  to  inflation  such  as  that  caused  by  war, 
the  experience  of  hundreds  of  years  emphasizes  the  dangers  of 
considering  such  inflated  prices  to  be  normal.  In  spite  of  inflation 
due  to  wars,  prices  usually  return  to  pre-war  levels,  and  it  is  reason- 
able to  assume  that  they  always  will.  It  was  said  that  the  recent 
World  War  was  different  from  all  others,  and  that  therefore  prices 
would  continue  permanently  on  a  higher  level.  Yet  in  192 1  the 
prices  of  some  important  basic  commodities  were  as  low  or  lower 
than  in  19 14. 

(b)  The  selection  of  a  low,  fixed  base  price  for  raw  materials 
is  a  practice  which  was  adopted  many  years  ago  by  some  of  the 
most  successful  and  far-seeing  business  men.^  There  must  be 
some  direct  connection  between  good  business  practice  and  good 
accounting  practice.  It  is  absurd  to  claim  that  any  successful 
business  or  any  industry  as  a  whole  is  subordinate  to  accounting 


4  See  page  125. 


INVENTORIES— GENERAL  PRINCIPLES  125 

methods.  If  business  practices  are  bad  and  accounting  methods 
are  good,  the  former  must  yield;  but  if  business  practices  are 
good,  accounting  methods  must  conform  to  them.  Good  business 
concerns  have  good  cost  systems,  but  when  market  conditions 
change  it  may  be  folly  to  expect  to  realize  cost.  Good  accounting 
practice  must  not  be  confused  with  good  accounting  methods. 
The  latter  will  produce  accurate  costs  by  means  which  are  largely 
mechanical  and  inflexible.  Good  accounting  practice  is  based  on 
opinion  and  therefore  is  flexible. 

Reserves  Against  Falling  Inventory  Values. — Some 
corporation  officials  thought  that  the  continued  rise  in  prices 
during  the  war  was  a  temporary  phenomenon,  and  so  took  such 
steps  as  were  necessary  to  prevent  a  serious  impairment  of  earn- 
ing power  in  the  event  of  a  return  to  lower  prices  during  succeed- 
ing years.  Thus,  the  United  States  Steel  Corporation  established 
a  reserve  during  the  years  1916  to  1920,  which  at  the  close  of  1920 
amounted  to  $95,000,000  on  an  inventory  of  $353,000,000.  This 
reserve  was  established  to  offset  the  excess  of  actual  cost  or  mar- 
ket value  of  inventory  stocks  over  and  above  the  unit  prices 
therefor  as  at  the  close  of  the  year  19 15.  Some  corporations 
carried  quantities  equal  to  the  war  quantities  at  pre-war  cost,  and 
increases  in  quantities  at  actual  cost. 

The  ^'Base"  Stock  Method. — To  be  conservative  and  for 
convenience  some  manufacturers  have  adopted  a  plan  of  carrying 
their  basic  raw  materials  through  their  accounts  and  in  their 
inventories  at  fixed  or  arbitrary  prices  irrespective  of  cost.  Brass 
manufacturers  frequently  have  carried  copper  at  10  cents  a  pound 
for  many  years,  during  which  time  copper  sold  for  a  considerably 
higher  price.  From  the  point  of  view  of  simplicity  this  custom  is 
like  the  sales  tax — it  is  very  simple  in  theory  but  dangerous  in 
practice.  If  costs  were  based  on  fixed-price  raw  materials,  the 
results  would  always  be  inaccurate;  balance  sheets  based  on  such 
fixed  prices  might  be  conservative,  but  would  be  inaccurate  and 
misleading.    Some  of  the  concerns  which  followed  this  plan  also 


126  AUDITING— GENERAL  PRINCIPLES 

wrote  down  their  plant  valuations  to  $1 .  This  also  was  conserva- 
tive practice  but  it  had  no  other  virtue  to  recommend  it. 

During  192 1  prices  of  some  commodities  declined  below  any 
previous  quotations.  It  is  probable  that  base  prices  would  have 
been  fixed  on  a  higher  basis.  Such  conditions,  which  of  course 
recur  from  time  to  time,  render  the  base-price  method  more  or 
less  unreliable.  If  frequent  adjustments  are  necessary  the  method 
should  not  be  used. 

On  the  other  hand,  the  method  has  much  to  recommend  it. 
At  the  beginning  of  the  late  war  it  was  believed  that  the  adoption 
of  the  base-  or  fixed-price  method  would  prevent  subsequent 
financial  troubles,  should  prices  unduly  increase.  Many  concerns 
adopted  it  and  those  which  adhered  to  it  now  consider  that  their 
judgment  has  been  vindicated.  The  Treasury  Department  re- 
fused to  sanction  the  practice  in  so  far  as  the  computation  of  in- 
come and  profits  taxes  is  concerned.  Who  is  right  is  a  question 
to  be  settled  by  the  courts.  ^ 

In  the  opinion  of  the  author,  the  method  was  adopted  by 
enough  concerns  to  justify  calling  it  good  accounting  practice. 


2.  When  Is  It  Proper  to  Value  an  Inventory  at  "  Cost  or  Market, 
Whichever  Is  Lower"? 

The  old  rule,  ''cost  or  market,  whichever  is  lower,"  permits 
in  some  cases  true  conditions  to  be  ignored  and  may  inject  into 
the  balance  sheet  a  false  and  misleading  element.  When  cost  is 
lower  than  value  and  inventories  are  priced  at  cost,  the  valuable 
principle  of  conservatism  is  followed ;  but  in  practically  all  cases 
the  balance  sheet  does  not  show  the  value  at  the  date  of  the  balance 
sheet.  The  mere  statement  that  assets  are  listed  at  cost  is  no  in- 
dication of  their  present  value '\Jhi  consequence,  all  sorts  of  in- 

/ferences  are  drawn  and  much,  if  not  all,  of  the  virtue  of  conserva- 
tism is  lost  because  of  the  vicious  practice  of  users  of  balance 

I  sheets  in  estimating  the  accrued  profit  thus  concealed.     The 


5  For  a  full  discussion  of  this  question,  see  Income  Tax  Procedure,  192: 
page  350. 


INVENTORIES— GENERAL  PRINCIPLES  1 27 

imagination  sets  no  limits  to  such  estimates.  Surely  it  is  better  to 
set  up  some  expression  of  value  at  the  date  of  the  balance  sheet  than 
to  employ  ''cost"  without  a  full  exposition  of  the  relation  of  cost 
to  value. 

The  substitution  of  ''market"  for  *'cost"  because  market  is 
lower  than  cost,  is  a  more  satisfactory  procedure  than  continuing 
at  cost  when  cost  is  far  below  market,  and  marks  the  approach  to 
a  more  scientific  and  accurate  statement.  At  the  present  time, 
however,  the  term  "market"  is  not  uniformly  defined. 

A  definition  promulgated  by  the  Treasury  early  in  1921^  is 
almost  ideal:  "Under  ordinary  circumstances  'market'  means 
the  current  bid  price  prevailing  at  the  date  of  the  inventory  for 
the  particular  merchandise  in  the  volume  in  which  ordinarily 
purchased  by  the  taxpayer."  This  is  a  definition  which  will  be" 
approved  by  the  courts  in  litigated  cases.  It  is  satisfactory  to 
business  men  and  credit  grantors.  Very  few  balance  sheets,  how- 
ever, have  adopted  the  principle  and  most  income  tax  examiners 
ignore  it.  The  principle  is  followed  in  theory,  but  in  practice  the 
most  vital  and  controlling  element  in  the  definition,  viz.,  "in  the 
volume  in  which  ordinarily  purchased,"  is  repudiated.  The 
pubHshed  quotation  for  crude  rubber  on  December  31,  1920,  was 
20  cents  a  pound.  The  cost  of  production  was  then  and  still  is 
more  than  20  cents  per  pound.  At  December  31,  1920,  what  was 
the  proper  method  of  valuing  crude  rubber  which  cost  30  cents 
per  pound  to  produce  and  which  had  cost  40  cents  per  pound? 
The  current  bid  price  was  20  cents  per  pound;  but  current  bid 
prices  almost  invariably  ignore  quantities  or  volume.  In  a  seller's 
market  large  purchases  result  in  an  advance  in  the  bid  prices;  in  a 
buyer's  market  large  sales  result  in  a  decrease  in  the  bid  prices. 
Those  who  intelligently  analyze  balance  sheets  are  interested  in  large 
quantities  and  in  the  influence  of  large  quantities  on  the  market. 
Fluctuations  affect  small  concerns  and  large  concerns  alike, 


^See  Article  1584  as  revised,  Regulations  45  (page  122  hereof).  The 
article  before  revision  was  unsound.  For  discussion  of  changes  see  Income  Tax 
Procedure,  1921,  pages  346  and  358,  and  previous  editions. 


128  AUDITING— GENERAL  PRINCIPLES 

except  when  a  small  concern  fills  its  requirements  or  sells  its 
products  in  a  market  not  participated  in  by  the  larger  concerns 
in  the  same  industry.  These  cases  are  rare  because  large  concerns 
do  not  stay  out  of  the  market  very  long  and  small  concerns  can- 
not, as  a  rule,  choose  their  own  times  to  trade.  Under  such  condi- 
tions professional  auditors  should  not  feel  boimd  by  any  inflexible 
rule.  The  basis  to  be  used  should  be  decided  upon  after  full  con- 
sideration of  special  circumstances.  A  clear  statement  of  the 
basis  decided  upon  in  good  faith  represents  good  accounting  prac- 
tice.   General  rules  are  not  intended  to  govern  exceptional  cases. 

Steel  prices  were  fixed  by  the  government  during  the  war  and 
up  to  December  31,  1918.  At  the  end  of  the  period  of  govern- 
mental price-fixing,  steel  manufacturers  reduced  prices  somewhat 
but  the  revised  quotations  were  productive  of  very  little  business. 
In  March,  191 9,  further  reductions  were  made.  There  are  avail- 
able trustworthy  ''market"  quotations  as  of  December  31,  1918, 
but  such  quotations  are  grossly  misleading  because  they  were 
purely  nominal.  The  business  done  at  those  quotations  was 
negligible.  All  attempts  to  sell  considerable  quantities  at  the 
"asked "  prices  met  with  failure.  Prospective  buyers  ignored  the 
pubHshed  ''bid"  prices  and  waited  for  lower  prices.  The  early 
reductions  in  the  "asked"  prices  proved  beyond  question  that 
purchasers  would  not  pay  the  former  "asked"  prices,  thus  show- 
ing the  danger  of  using  pubHshed  quotations  unless  the  volume 
of  business  done  at  such  quotations  is  known.  For  balance  sheet 
purposes  as  at  December  31,  1918,  "the  current  bid  prices  (for 
steel)  prevailing  at  the  date  of  the  inventory"  were  not  the  pub- 
lished quotations  but  were  substantially  lower  prices  because  no 
considerable  quantity  of  steel  was  sold  between  January  and 
March,  1919.^ 

It  is  true  that  in  periods  of  depression  some  goods  cannot  be 
sold  at  any  fair  price.    It  would  be  idle  to  take  bid  prices  under 


'  The  author  was  a  member  of  the  governmental  price-fixing  committee 
and  participated  in  the  conferences  before  and  atter  January,  191 9;  therefore 
he  speaks  from  personal  knowledge  of  the  facts. 


INVENTORIES— GENERAL  PRINCIPLES  129 

such  conditions  as  criteria,  because  the  sellers  usually  can  afford 
to  carry  unsalable  stocks  better  than  those  who  do  not  wish  to 
buy,  and  usually  can  afford  to  carry  stocks  just  as  well  as  those 
who  would  pay  *'junk"  prices  and  carry  the  stocks  as  a  specula- 
tion. The  usual  free  credit  which  would  be  extended  to  those  who 
might  be  expected  to  buy  for  future  needs  is  contracted  almost  to 
the  vanishing  point. 

During  the  year  1920  radical  fluctuations  occurred  in  the  ^ 
prices  and  values  of  most  commodities.    At  the  beginning  of    ? 
1920  many  inventories  were  taken  at  ^'  cost,"  which  was  supposed    * 
to  be  less  than  "market."    At  the  end  of  1920  many  inventories 
were  taken  at  "market"  which  was  supposed  to  be  less  than 
"cost."    The  conditions  were  ideal  for  testing  the  old  rule;  it  was 
intended  to  be  inflexible  and  it  alone  was  held  to  represent  good 
accounting  practice;  but  widely  different  interpretations  were 
placed  upon  the  words  " cost "  and  "market."    If  the  matter  had 
been  left  to  professional  auditors  they  would  have  ruled  that  at 
the  end  of  1919  "cost"  should  have  been  interpreted  to  mean 
normal  or  reasonable  cost,  not  temporary  costs  resulting  from 
inflated  prices  of  material  and  labor;  and  at  the  end  of  1920  they 
would  have  interpreted  "market"  to  mean  realizable  values. 
The  nominal  quotations  which  existed  could  not  have  been  and 
were  not  realized  in  most  cases.    Bankers  were  keen  to  know  that 
the  rule  of  cost  or  market  was  observed,  but  due  to  a  lack  of  gen- 
eral understanding  as  to  the  meaning  of  the  word  "market"  many 
misunderstandings  occurred.     The  term   "normal  costs"   can 
hardly  be  used  unless  costs  are  fairly  uniform  over  a  period  of  not 
less  than  three  years.    Therefore,  in  a  rapidly  rising  market  ac- 
countants would  have  persuaded  their  cHents  to  value  inven- 
tories below  the  temporary  costs.    The  United  States  Steel  Cor- 
poration did  adopt  this  method.-  The  mere  creation  of  contin-  i 
gency  reserves  is  not  good  accounting  practice.    Every  intelligent   I 
user  of  a  balance  sheet  knows  that  the  entire  surplus  is  a  con-J 
tingency  reserve.    It  is  good  accounting  practice  to  set  up  specific 
reserves  and  to  segregate  surplus  for  certain  purposes,  but  it  is 

VOL.  I — 9 


I30  AUDITING— GENERAL  PRINCIPLES 

not  good  accounting  practice  to  inflate  assets  and  then  carry 
general  reserves  against  such  assets. 

When  available  information  demands  the  writing  down  of 
current  assets,  they  should  be  written  down  against  current  in- 
come. When  such  information  is  not  available  and  only  a  sus- 
picion to  that  effect  exists,  it  is  not  good  practice  to  write  down 
the  assets  or  to  set  up  reserves  against  them,  because  contingency 
reserves  are  not  charged  against  current  income;  therefore,  if 
such  reserves  are  used  in  the  following  fiscal  period,  there  is  no 
charge  against  income  in  either  period.  In  other  words,  current 
operating  losses  are  in  efifect  charged  directly  to  surplus.  It  is 
highly  desirable  to  explain  any  extraordinary  items  in  a  current 
income  accoimt,  but  there  is  no  excuse  for  leaving  them  out 
solely  because  they  are  extraordinary. 

At  the  beginning  of  1920  most  inventories  were  carried  at 
prices  far  in  excess  of  the  values  which  were  later  realized.  It  is 
contended  by  some  that  the  practice  at  that  time  was  justified, 
(a)  because  current  costs  were  not  going  down,  but  were  increas- 
ing, and  (b)  because  orders  greatly  exceeding  entire  existing  in- 
ventories were  in  hand  or  in  sight.  The  fallacy  of  this  contention 
was  demonstrated  early  in  the  year  1920.  So-called  firm  orders 
amounting  to  himdreds  of  millions  of  dollars  were  canceled.  So- 
called  market  prices  melted  Hke  snow  on  a  hot  day.  In  many 
cases  declines  exceeded  the  entire  profits  for  the  year  1919.  In 
some  cases  the  actual  values  of  inventories  were  known  before 
tax  returns  for  1919  were  made  up;  yet  the  fear  heretofore  re- 
ferred to  was  so  great  that  imaginary  market  values  were  placed 
upon  December  31,  1919,  inventories,  and  excessive  taxes  were 
paid  upon  such  valuations.  Professional  auditors  are  not  sup- 
posed to  be  prophets  but  many  of  them  went  on  record  that  ap- 
parent market  prices  at  that  time  were  not  actual  market  prices. 
The  author  prophesies  that,  when  the  United  States  courts  com- 
mence to  pass  upon  the  fair  market  value  of  December  31,  1919, 
inventories,  some  of  the  fallacies  of  existing  definitions  will  be 
exposed. 


INVENTORIES— GENERAL  PRINCIPLES  I3I 

At  the  end  of  1920  the  situation  was  reversed.  The  apparent 
"market"  value  of  many  commodities  was  lower  than  replace- 
ment costs,  and  in  some  cases  it  was  below  any  possible  future 
replacement  costs.  The  term  ''market, "  as  defined  for  inventory 
purposes,  was  restricted  to  the  nominal  bid  quotations  at  that 
time.  At  the  beginning  of  1920  there  were  no  willing  sellers;  the 
buyers  were  in  a  panic.  At  the  end  of  1920  there  were  no  willing 
buyers ;  the  sellers  were  in  a  panic.  The  courts  have  defined ' '  mar- 
ket value"  to  be  the  price  at  which  a  seller,  willing  to  sell  at  a 
fair  price,  and  a  buyer  willing  to  buy  at  a  fair  price,  both  having 
reasonable  knowledge  of  the  facts,  will  trade.  ^ 

The  rule,  ''cost  or  market,  whichever  is  lower,"  was  adopted 
to  encourage  safe  and  sound  business  practice,  and  at  the  end  of 
1919  should  have  been  interpreted:  "market  prices"  means 
"realizable"  market  prices. 

The  Rule  Should  Be  More  Flexible  to  Cover  All 
Conditions. — When  literally  interpreted,  the  rule  of  "cost  or 
market,  whichever  is  lower"  fails  not  because  of  the  intention 
back  of  it,  but  because  the  intention  cannot  be  expressed  in  a  few 
words.  It  is  always  desirable  to  have  rules  as  short  as  possible, 
but  it  is  better  to  have  them  long  and  clear  than  short  and  ob- 
scure. Experience  has  shown  that  "cost"  and  "market"  are 
words  of  widely  different  application  and  meaning.  Since  the 
original  intention  of  the  rule  was  clear  to  the  accountants  who 
worked  it  out,  the  intention  should  have  been  set  forth  as  a  part 
of  the  rule.  The  author  does  not  propose  an  entirely  new  rule  but 
beHeves  that  good  accounting  procedure  can  be  accurately  re- 
flected through  reasonable  interpretation.  ""^ 


ed     j 

of     t 

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'V 


8  "In  the  matter  of  Cliquot's  Champagne,  Judge  Hoffman  defined  the 
market  value  of  goods  to  be  'the  price  at  which  the  owner  of  the  goods,  or  the 
producer,  holds  them  for  sale;  the  price  at  which  they  are  freely  offered  in  the 
market  to  all  the  world;  such  prices  as  dealers  in  the  goods  are  willing  to  re- 
ceive, and  purchasers  are  made  to  pay,  when  the  goods  are  bought  and  sold  in 
the  ordinary  course  of  trade ' ;  and  the  definition  was  approved  by  this  court. 
Cliquot's  Champagne,  3  Wall  114,  125,  142.  We  regard  it  as  quite  sufficient  for 
the  inquiry  here  .  .  .  . "  (Muser  v.  Magone,  155  U.  S.  240.  October  term, 
1894.) 


132  AUDITING— GENERAL  PRINCIPLES 

VARLA.TIONS  IN  BALANCE  ShEET  VALUATIONS  OF  INVENTORIES. 

— The  author  has  analyzed  more  than  one  hundred  balance 
sheets  of  well-known  corporations,  as  of  December  31,  1920,  and 
as  of  the  close  of  fiscal  periods  ending  several  months  before  and 
after  that  date,  in  order  to  ascertain  the  prevaiHng  method  of 
valuing  inventories.  Nearly  all  of  these  balance  sheets  were 
certified  by  reputable  auditors;  and  any  method  adopted  by  the 
majority  of  these  auditors  may  be  considered  good  accounting 
practice.  It  is  not  customary  to  state  the  method  of  valuation  on 
the  face  of  balance  sheets,  but  in  many  cases  the  auditor's  cer- 
tificate or  the  president's  report  specifically  states  that  the  in- 
ventory is  valued  at  cost  or  market,  whichever  was  lower;  in 
many  cases  the  statement  is  made  that  market  values  were  far 
below  cost,  and  in  some  cases  the  amount  required  to  write  down 
cost  to  market  was  mentioned.  In  a  few  cases  provision  was 
made  to  write  purchase  commitments  down  to  market. 

In  several  cases  inventories  were  carried  at  cost.  Criticism 
must  have  been  anticipated,  because  explanations  were  made  in 
defense  of  the  basis  of  valuation  used.  In  one  case  it  was  stated 
that  the  inventories  were  to  be  applied  to  specific  sales  orders. 

In  another  case  the  statement  was  made  that  new  products 
were  valued  at  *' sales  prices,  net";  the  obvious  meaning  being 
that  the  new  products  were  costing  more  than  they  were  selHng 
for. 

As  commented  on  elsewhere,  ^  some  inventories  of  goods  which 
contained  a  profit  were  carried  at  sales  prices.  It  was  not  always 
so  stated,  but  it  may  be  assumed  that  in  all  cases  the  sales  prices 
were  net  of  delivery  and  similar  charges. 

In  some  cases  when  inventories  were  written  down  to  market, 
the  prices  were  no  greater  than  those  prevailing  at  the  commence- 
ment of  the  war.  In  those  industries  where  prices  at  the  end  of 
1920  were  still  substantially  above  pre-war  prices,  only  one  case^** 


9  See  page  148. 

"The  United  States  Steel  Corporation.     See  annual  report  for  1920, 
pages  32  and  33,  and  comment  thereon,  page  16  thereof. 


INVENTORIES— GENERAL  PRINCIPLES  I33 

was  found  where  it  was  made  plain  that  a  reserve  was  carried 
to  reduce  the  inventory  to  pre-war  prices. 

One  corporation ' '  valued  crude  rubber  at  a  price  well  above 
market  price;  the  unit  price  was  given  but,  as  the  quantity  was 
not  shown,  it  was  impossible  to  determine  from  the  annual  report 
the  amount  involved. 

The  certificates  to  most  of  the  best  balance  sheets  indicate 
that  the  auditors  made  critical  investigations  of  the  inventory 
items.  In  some  cases  quahfications  appear,  usually  stating  that 
quantities  were  vouched  for  by  responsible  officers,  but  usually 
the  auditors  certify  to  the  accuracy  of  the  inventories.  This  is  as 
it  should  be.  In  the  second  edition  of  this  book,'^  the  author 
stated  that  stock-taking  was  the  most  important  element  in 
business,  and  that  bankers,  stockholders,  and  others  were  not 
satisfied  with  the  reluctance  of  many  auditors  to  avoid  verifying 
inventories.  As  the  demand  increased,  auditors  devoted  more 
attention  to  the  subject,  so  that  today  most  reputable  auditors 
are  fully  able  to  pass  upon  every  element  of  inventories. 

There  are  many  cases  when  auditors  do  not  accept  responsibil- 
ity for  quantities  and  so  state  in  their  certificates.  It  is  good 
accounting  practice  to  certify  with  the  reservation;  but  when  it  is 
feasible,  the  certificate  without  the  reservation  is  more  acceptable. 
As  stated  in  other  chapters,  it  is  possible  to  certify  to  the  accuracy 
of  work  done  by  others  without  verifying  every  item  or  trans- 
action.'^ 

Evolution  of  Rules  of  Valuation. — At  one  time  it  was 
the  practice  to  take  inventories  at  cost,  market,  or  net  selling 
prices,  depending  on  the  attitude  of  the  owners  of  the  concerns 
affected.  There  was  no  uniformity  in  method  and  arbitrary 
changes  were  made  to  meet  temporary  conditions.  Professional 
auditors  were  responsible  for  the  subsequent  standardization  of 
methods.    The  underlying  purpose  of  standardization  was  con- 


'^  See  page  143. 
'»  Pages  86  and  87. 
*3  See  page  430. 


134  AUDITING— GENERAL  PRINCIPLES 

servatism,  not  the  scientific  determination  of  results  for  a  particu- 
lar period.  Values  in  a  true  sense  were  often  ignored  in  stating 
results,  in  order  that  the  term  "profits"  might  be  limited  to 
realized  profits  rather  than  to  accrued  profits.  This  theory  has 
been  carried  to  an  unnecessary  extreme,  but  as  an  expedient  to 
prevent  anticipation  of  profits  it  has  worked  exceedingly  well. 

The  rule  evolved  was  that  inventories  of  goods,  materials, 
securities,  and  all  other  current  assets  should  be  valued  at  the 
actual  cost  thereof  unless,  due  to  a  decline  in  values,  the  market 
or  replacement  price  was  lower  than  cost;  in  all  cases  the  lower  of 
the  two  was  to  be  used.  Cost  was  construed  to  exclude  interest 
on  the  investment  and  selling  and  administrative  expenses;  mar- 
ket was  intended  to  mean  replacement  cost  of  such  part  of  the 
inventory  as  would  normally  be  replaced.  Overstocks,  obsolete 
goods,  and  other  undesirable  stocks  were  supposed  to  be  marked 
down  to  actual  values.  When  market  prices  were  above  cost  it 
was  recognized  that,  on  the  same  principle  or  basis  of  actual 
values,  the  inventory  should  be  written  up;  but  expediency  and 
conservatism  prevented  any  reflection  of  the  unrealized  increases 
in  values  except  as  a  footnote  to  a  balance  sheet  or  comment  in 
an  audit  certificate. 

Tendency  of  Valuations  Before  1917. — In  a  few  industries 
where  costs  were  difficult  to  determine,  inventories  were  taken  at 
net  selling  prices,  but  such  exceptions  were  rare.  Prior  to  19 17 
there  was  a  tendency  to  overvalue  inventories  and  auditors  had  a 
fairly  hard  time  enforcing  the  rule.  Commencing  with  the  end  of 
191 7,  due  to  the  influence  of  the  income  and  excess  profits  taxes, 
there  was  a  tendency  to  undervalue  inventories;  consequently, 
the  auditor  who  formerly  preached  the  gospel  of  conservatism 
found  himself  arguing  with  his  client  against  a  material  under- 
valuation of  his  inventory. 

Meaning  of  Term  ''Inventory  at  Cost.  " — The  term  ''cost 
of  product"  may  have  but  little  connection  with  the  term  "in- 
ventory valued  at  cost"  in  a  balance  sheet.     Merchants  and 


INVENTORIES— GENERAL  PRINCIPLES  135 

manufacturers  are  vitally  interested  in  ascertaining  total  costs  of 
production.  Competition  may  fix  selling  prices,  it  may  be  feasible 
to  add  a  fixed  percentage  to  cost,  or  the  demand  may  be  so  great 
that  sales  prices  have  little  relation  to  cost;  but,  whatever  sales 
prices  may  be,  it  is  important  to  have  trustworthy  information 
regarding  costs.  An  inventory  ^'at  cost"  may  be  based  upon  a 
cost  system  which  is  satisfactory  to  the  owners  or  managers  of  a 
business,  but  it  may  be  necessary  to  adjust  the  valuations  in  order 
that  bankers  and  creditors  will  not  be  deceived. 

In  the  Federal  Reserve  Board's  proposal  for  uniform  account- 
ing, 27  points  are  mentioned  regarding  inventories.  Point  17  (a) 
is:  ^'That  no  selling  expenses,  interest  charges,  or  administrative 
expenses  are  included  in  the  factory  overhead  cost."  Point  27  is: 
"It  may  be  well  to  reiterate  that  interest,  selling  expenses,  and 
administrative  expenses  form  no  part  of  the  cost  of  production, 
and  therefore  should  not  be  included  in  the  inventory  in  any 
shape.  "^4 

Determination  of  Average  Costs. — The  foregoing  rule 
should  be  insisted  upon;  moreover,  care  must  be  used  to  eliminate 
from  inventories  "at  cost"  any  other  items  which  good  account- 
ing practice  requires  to  be  eliminated.  Good  accounting  practice 
is  not  inflexible;  generally  speaking,  it  requires  that,  if  at  the  end 
of  a  fiscal  period  inventories  are  to  be  valued  at  cost,  all  items 
must  be  excluded  from  inventory  valuations  except  factory  costs, 
and  that  no  doubtful  items  may  be  included.    When  the  costs  of 


^4  "The  term 'Cost' means:  (i)  Cost  of  material  and  supplies.  (2)  Cost 
of  direct  labor.  (3)  A  fair  proportion  of  overhead  expenses.  By  the  term 
'overhead  expenses'  is  meant  the  indirect  labor  and  other  manufacturing  ex- 
penses, and  the  general  and  administrative  expenses  applicable  to  and  neces- 
sary in  connection  with  the  production  of  the  articles  contracted  for  ....  It 
does  not  include  (among  other  items)  the  following:  Interest,  rent,  advertising, 
collection  expenses,  credit  losses  and  customers'  discounts,  and  such  taxes  as 
income  and  excess  profits  taxes  imposed  by  the  United  States  Government, " 
(Uniform  Contracts  and  Cost  Accounting  Definitions  and  Methods,  U.  S. 
Government  Interdepartmental  Conference,  19 17,  page  7.) 

"  Standard  methods  of  distribution  of  overhead  are  first,  direct  labor  cost; 
second,  direct  labor  hours;  third,  machine  hours. 

*'....  The  method  of  distribution  of  overhead  by  the  direct  labor  hours 
is,  in  the  majority  of  cases,  the  most  accurate  method. "    (Ibid.,  page  12.) 


136  AUDITING— GENERAL  PRINCIPLES 

materials  are  averaged  over  a  period  of  time,  it  becomes  neces- 
sary to  analyze  the  most  recent  costs  and  purchases.  If  costs  are 
rising,  average  cost  prices  will  be  somewhat  lower  than  the  most 
recent  costs,  so  that  it  should  then  be  noted  that  the  inventory  is 
priced  ''at  cost  or  less."  If  prices  are  falling,  average  cost  prices 
will  be  in  excess  of  current  replacement  costs  (market)  so  that  the 
inventory  valuations  must  be  reduced. 

If  the  client  declines  to  change  the  inventory  valuations,  and 
if  the  auditor  is  asked  to  certify  that  the  inventory  is  valued  at 
cost,  the  question  arises,  ''What  will  be  understood  by  the  word 
'cost'?"  One  concern  may  have  started  with  large  quantities  of 
raw  materials  at  high  prices  and  the  average  cost  may  be  very 
high;  another  concern  manufacturing  the  same  kind  of  product 
may  have  much  lower  average  costs.  Their  inventories  may 
contain  the  same  number  of  units  representing  a  considerable 
difference  in  aggregate  costs.  Those  who  extend  credit  to  such 
concerns  may  easily  be  misled  by  the  use  of  the  word  "cost"; 
therefore  an  auditor,  when  certifying  to  a  balance  sheet  in  which 
inventories  appear  at  cost,  should  endeavor  to  have  the  balance 
sheet  contain  a  full  disclosure  of  base  prices  used  or  other  data 
which  will  enable  those  who  use  the  balance  sheet  to  compute 
the  difference  between  the  cost  prices  used  and  replacement  cost. 

Reductions  in  labor  costs  and  in  costs  of  manufacture  due  to 
use  of  improved  machinery  or  processes,  may  become  effective 
immediately  before  the  date  of  a  balance  sheet.  In  reducing  in- 
ventories to  market  value  (where  market  value  and  replacement 
costs  are  assumed  to  be  the  same),  such  decreasing  costs  are  as 
important  a  factor  as  decreases  in  the  cost  of  raw  materials. 
When  selling  values  decline  and  costs  decline,  the  downward  trend 
cannot  be  attributed  solely  to  lower  replacement  costs  of  mate- 
rials rather  than  to  lower  labor  or  other  costs. 

In  the  following  discussion  questions  of  deterioration,  changes 
in  style,  fluctuation  in  prices,  etc.,  are  ignored.  These  questions 
are  fully  dealt  with  elsewhere. 

DeaHng  with  purchased  goods  or  materials: 


INVENTORIES— GENERAL  PRINCIPLES  I37 

1 .  Specific  Purchases  on  Hand.  When  only  specific  purchases 
are  on  hand  at  date  of  inventory,  the  purchase  price  as  shown  by 
the  latest  invoices  is  to  be  used  except  when  the  stock  on  hand  is 
allocated  to  fill  a  particular  order  and  a  previous  purchase  to  fill 
such  order  was  used  on  another  order.  A  concern  received  two 
contracts  each  requiring  1,000  tons  of  pig  iron.  When  contract 
A  was  taken,  iron  was  ordered  at  cost  $25  per  ton  and  the  contract 
was  based  on  $25  iron.  When  contract  B  was  taken  iron  at  $30 
per  ton  was  ordered.  Contract  B  was  completed  first  but  the  $25 
iron  was  first  received  and  consumed.  At  the  end  of  the  period 
contract  A  was  not  completed  and  there  were  on  hand  1,000  tons 
of  iron  (purchased  against  contract  B)  which  cost  $30  per  ton. 
If  the  iron  were  inventoried  at  $30,000,  it  would  result  in  contract 
B  (completed)  showing  a  profit  of  $5,000  more  than  was  antici- 
pated and  in  the  next  period  contract  A  would  be  completed  with 
a  profit  of  $5,000  less  than  was  expected.  With  the  probability 
of  different  persons  being  interested  in  the  results  of  the  two 
periods,  it  would  obviously  be  improper  to  distort  the  accounts  of 
back  periods  merely  to  follow  an  old  rule  that  the  last  price  of 
recent  purchases  is  the  invoice  price.  The  actual  situation  is 
that  lot  B  takes  the  place  of  and  replaces  lot  A,  that  lot  A  is  in 
effect  on  hand,  and  the  true  cost  of  the  iron  in  the  inventory  is 
$25  per  ton.  If  the  situation  were  reversed  it  would  be  proper  to 
inventory  iron  which  cost  $25  per  ton  at  $30  per  ton,  provided 
the  incompleted  contract  were  in  every  way  a  good  asset. 

2.  Different  Lois  at  Different  Prices.  When  different  lots 
have  been  purchased  at  different  prices,  the  strictly  accurate  cost 
of  the  quantity  of  a  specific  article  in  the  inventory  is  that  paid 
for  the  latest  quantities,  working  back  through  the  invoices  and 
taking  the  sum  of  invoices  representing  the  aggregate  quantity 
in  the  inventory.  But  this  method  is  not  feasible  in  practice, 
because  old  purchases  at  old  prices  must  be  disposed  of.  When- 
ever there  is  a  mingling,  or  a  possible  mingling,  of  goods  or  mate- 
rials, the  cost  prices  also  are  mingled.  It  is  quite  easy  to  reason 
otherwise  but  the  line  of  reasoning  is  fallacious.    For  bookkeep- 


138  AUDITING— GENERAL  PRINCIPLES 

ing  purposes  it  is  possible  to  show  that  various  lots  are  consumed 
at  different  times.  By  a  little  juggling  it  can  be  shown  that  out  of 
four  lots  of  the  same  kind  of  materials  costing  different  prices, 
any  one  lot  is  entirely  used  before  any  other,  and  at  inventory 
time  the  ^'cost"  of  the  quantity  remaining  (consisting  of  only  one 
lot)  may  be  that  of  any  one  of  the  lots.  In  fact,  if  the  goods  are 
the  same,  consumption  is  sure  to  follow  the  line  of  least  resistance, 
or,  in  other  words,  those  lots  will  be  used  first  which  are  most 
conveniently  situated.  We  must  remember  that  we  are  dealing 
with  goods  which  are  not  used  up  as  purchased  but  that  new  lots 
are  received  before  the  old  ones  are  disposed  of. 

During  a  given  period  we  deal  with  the  cost — not  the  value — 
of  what  we  buy.  The  value  of  what  remains  at  the  end  of  the 
period  is  fixed  by  the  market  at  the  same  time.  The  cost  of  what 
is  on  hand  is  an  average  cost. 

When  monthly  costs  are  determined,  the  purchases  (quanti- 
ties and  costs)  during  each  month  are  added  to  the  balances 
brought  forward  at  the  beginning  of  the  month,  and  an  average 
cost  is  determined  by  dividing  the  total  quantity  into  the  total 
money  figures.  This  method  is  better  than  merely  taking  an 
arithmetical  average  of  invoice  prices.  Unless  an  average  is 
*' weighted "^^  it  is  erroneous. 

Vagueness  of  the  Term  "Cost." — ^We  usually  refer  to 
"cost"  as  if  it  were  an  exact  term  and  not  to  be  compared  with 
the  elusive  word  "market."  Experienced  accountants  often  find 
it  difficult  to  determine  costs,  even  when  all  factors  are  known; 
when  some  factors  are  not  known  it  is  impossible  to  determine 
accurate  costs,  and  so  estimates  must  be  substituted.  Even  when 
a  specific  purchase  of  goods  is  on  hand  at  the  date  of  an  in- 


^s  A  "weighted"  average  is  one  computed  by  giving  due  weight  or  con- 
sideration to  all  of  the  elements  which  enter  into  the  calculation.  When  lOO 
shares  of  stock  sell  for  $80  a  share,  and  1,000  shares  sell  for  $70  a  share,  it  may- 
be said  that  the  average  sales  price  is  $75  a  share.  But  if  the  sales  were  made 
by  the  same  person,  he  would  deny  that  the  average  price  was  $75.  He  would 
say  that  the  average  price  was  about  $71  per  share  and  prove  it  by  showing  a 
cheque  for  $78,000,  the  proceeds  of  the  sale  of  his  1,100  shares. 


INVENTORIES— GENERAL  PRINCIPLES  I39 

ventory,  it  may  be  inaccurate  to  include  such  purchase  in  the 
inventory  at  its  cost. '  ^  When  different  purchases  are  made  at 
different  prices  and  when  all  raw  materials  fluctuate  in  price, 
the  difficulties  of  arriving  at  accurate  cost  prices  are  very 
great. 

These  difficulties  can  be  overcome  under  a  good  accounting 
system;  but  it  is  nevertheless  important  that  uniform  methods  be 
followed  or  else  comparisons  of  the  financial  statements  of  one 
concern  with  those  of  another  will  be  misleading.  There  is  no 
good  reason  why  the  words  "inventory  at  cost''  should  mean  one 
thing  in  one  balance  sheet  and  another  thing  in  some  other 
balance  sheet.  If  we  state  and  discuss  the  problems  it  may  be 
possible  to  agree  on  uniform  practice.  Inventories  are  usually 
divided  into  four  groups,  viz. : 

1.  Raw  materials  or  goods  purchased,  on  hand  and  in  the 

same  condition  as  when  purchased. 

2.  Goods  in  process  of  conversion  or  manufacture. 

3.  Manufactured  or  converted  goods. 

4.  All  other  materials  and  supphes. 

The  four  groups  mentioned  are  discussed  in  detail  in  Chapter 
IX.  There  are  several  points  in  the  determination  of  cost  which 
must  be  understood  before  applying  the  term  "cost"  to  an  in- 
ventory as  a  whole. 

Arbitrary  Methods  of  Finding  "Cost." — To  arrive  at 
cost,  arbitrary  methods  must  sometimes  be  used.  The  proceeds 
of  the  sales  of  by-products  are  usually  apphed  against  the  cost  of 
production  of  the  main  product  without  regard  to  the  cost  of 
producing  the  by-products.  In  the  anthracite  coal  industry  the 
so-called  "small"  sizes  are  sold  for  less  than  cost  of  production 
because  of  competition  with  bituminous  coal.  The  value  of  gold 
is  deducted  from  the  cost  of  mining  copper  or  silver  or  lead.  In 
some  other  industries  in  which  products  of  more  than  one  grade 


'^  See  page  141  for  illustration. 


140  AUDITING— GENERAL  PRINCIPLES 

are  obtained  by  a  common  operation,  the  cost  of  any  one  product 
is  more  or  less  arbitrary.  In  the  packing  industry  by-products 
such  as  hides,  wool,  and  lard  are  credited  at  market  or  selling 
prices  against  the  cost  of  fresh  carcass  meats.  In  the  packing, 
as  in  the  oil,  industry  one  imit  of  raw  material  is  broken  up  into 
many  products,  instead  of  many  raw  materials  being  brought 
together  into  one  unit  of  finished  product. 

Under  such  diverse  conditions  it  is  regarded  as  good  account- 
ing practice  to  assign  higher  costs  to  more  valuable  products  and 
lower  costs  to  less  valuable  products,  even  though  the  apparent 
cost  of  production  of  each  grade  is  the  same.  This  is  practically 
the  same  as  working  back  from  the  selling  prices.  Whatever 
objection  may  be  made  to  this  rough  and  ready  method,  it  is  less 
likely  to  deceive  than  many  elaborate  cost  systems.  It  is  well  to 
reiterate  that  good  business  practices  and  good  accoimting  prac- 
tices must  go  hand  in  hand. 

Can  Appreciation  Be  Included  in  Costs? — It  is  incon- 
sistent to  argue  that  the  word  ''cost,"  in  its  common  meaning, 
should  include  any  element  of  appreciation  or  imearned  incre- 
ment. A  steel  company  may  be  mining  certain  ore  for  which  it 
pays  a  royalty  of  25  cents  per  ton,  and  it  may  be  mining  inferior 
ore  for  which  it  pays  a  royalty  of  50  cents  per  ton.  It  may  also  be 
purchasing  ore  in  the  market  at  a  price  which  is  equivalent  to  the 
payment  of  $1  per  ton  royalty.  Strictly  speaking,  "cost"  in- 
cludes the  actual  cash  outlay  irrespective  of  appreciation  or 
bargain  purchases.  Unless  a  balance  sheet  or  audit  certificate 
states  otherwise,  it  is  to  be  presumed  that  the  word  "cost"  ex- 
cludes all  appreciation. 

In  view  of  many  revaluations  as  at  March  i,  1913  (when  a 
separation  into  capital  and  income  became  of  more  importance 
than  accounting  rules  based  on  expediency),  there  is  no  impro- 
priety in  using  values  (instead  of  cost)  of  that  date  in  computing 
costs.  When  market  values  are  above  cost  and  the  revaluation 
basis  has  been  used  in  arriving  at  cost,  mention  should  be  made 


INVENTORIES—GENERAL  PRINCIPLES  141 

thereof  either  on  the  face  of  the  balance  sheet  or  in  the  audit 
certificate. 

When  a  balance  sheet  is  being  prepared  to  be  used  as  the 
basis  for  the  sale  of  a  business,  actual  values  should  be  shown 
irrespective  of  cost.  The  basis  of  valuation  should  be  shown 
on  the  balance  sheet  accompanied  by  a  notation  pointing  out 
the  variation  from  the  usual  method  hitherto  followed  in  that 
concern. 

3.  When  Is  It  Proper  to  Value  an  Inventory  at  Reproduction 
Cost,  It  Being  Higher  Than  Replacement  Cost? 

If  balance  sheets  are  intended  to  reflect  true  values,  unsound 
theories  of  balance  sheet  construction  must  be  abandoned. 
*' Value"  and  ^'cost"  are  rarely  the  same.  Ordinarily,  a  thing  is 
worth  something  more  or  less  than  it  cost,  assuming  always  that 
those  who  prepare  and  those  who  read  balance  sheets  have  the 
same  conception  of  cost;  usually,  of  course,  they  do  not.  Even 
when  there  is  agreement  as  to  the  meaning  of  the  word  "cost," 
it  usually  happens  that  at  the  date  of  a  balance  sheet  the  cost  of 
replacement  is  either  more  or  less  than  the  actual  cost  of  the  goods 
in  the  inventory.  Reproduction  cost  at  the  date  of  an  inventory 
is  not  a  good  criterion  of  value,  because  in  an  advancing  market 
the  value  of  finished  product  is  higher  than  reproduction  cost, 
whereas  in  a  decHning  market  the  sales  value  of  finished  product 
is  frequently  far  below  reproduction  cost. 

This  has  no  bearing  on  the  importance  of  knowing  accurate 
costs.  It  is  of  the  greatest  importance  to  know  whether  it  costs 
$1  or  $2  to  produce  a  given  unit;  but  if  there  are  1,000  units  on 
hand  at  inventory  time,  true  balance  sheet  values  do  not  require 
that  the  quantity  still  on  hand  must  be  valued  at  $1,000  or  at 
$2,000  merely  because  that  was  the  cost  or  the  average  cost  when 
the  units  were  produced.  The  cost  to  a  competitor  may  have 
been  $1,500;  the  replacement  cost  may  be  $1,200;  the  apparent 
market  value  may  be  $1,400.  What  is  required  today  is  in- 
dependent, impartial,  and  fearless  judgment  applied  to  the  quan- 


142  AUDITING— GENERAL  PRINCIPLES 

tity  on  hand  at  the  date  of  the  balance  sheet  and  an  estimate  of 
the  value  of  the  quantity  expressed  on  the  balance  sheet. 

Cost  records  have  their  place — a  very  important  place — but  in 
balance  sheet  construction  it  is  a  subordinate  place. 

The  term  "market  price"  should  be  used  synonymously  with 
"replacement  price"  whenever  inventory  valuations  of  finished 
goods  are  under  consideration.  Market  price  means  the  price 
at  which  one  can  buy;  sales  price  means  the  price  at  which  one 
can  sell.  In  determining  market  values,  inquiries  are  made  to 
ascertain  the  prices  at  which  goods  can  be  bought,  which  presum- 
ably is  less  than  the  prices  at  which  they  can  be  resold.  It  should 
be  possible  to  manufacture  goods  at  lower  prices  than  they  can  be 
purchased  for  from  others;  but  such  is  not  always  the  case.  In 
times  of  depression  concerns  frequently  buy  goods  at  less  than 
cost  of  reproduction;  in  times  of  inflation  they  pay  more  than  cost 
of  reproduction.  Replacement  cost  may  be  more  or  less  than 
market  price  when  a  concern  does  its  own  manufacturing  or  con- 
verting; but  when  a  concern  buys  to  resell  in  the  same  form,  the 
replacement  cost  is  the  same  as  the  market  price. 

In  the  case  of  manufacturers,  when  replacement  cost  is  less 
than  the  actual  or  original  cost  of  the  goods  in  the  inventory,  the 
inventory  should  be  reduced  to  replacement  cost.  When  repro- 
duction cost  is  more  than  apparent  market  or  replacement  prices, 
it  might  appear,  and  it  is  urged,  that  there  is  some  justification  for 
valuing  the  inventory  at  reproduction  cost  when  it  is  believed 
that  market  prices  are  unduly  depressed,  that  considerable  quan- 
tities cannot  be  purchased  at  the  apparent  market  prices,  and 
that  the  inexorable  law  of  supply  and  demand  will  in  time  raise 
the  market  prices  to  something  above  cost  of  reproduction. 

In  considering  the  factors  involved  it  must  be  borne  in  mind 
that  one  reason  why  the  market  price  is  low  is  because  there  are 
some  who  believe  that  reproduction  costs  will  decrease. 

In  the  annual  report  of  a  large  rubber  concern  for  the  year 
ended  December  31, 1920,  appears  this  reference  to  the  inventory 
of  crude  rubber: 


INVENTORIES— GENERAL  PRINCIPLES  143 

The  year  1920  opened  with  crude  rubber  (first  latex  crepe)  at  55  cents 
a  pound  and  closed  below  20  cents  a  pound.  Your  company  carried  over 
about  seven  months'  supply  of  crude  on  hand  and  to  arrive  at  26.79  cents, 
which  is  below  the  average  cost  of  production,  and  with  the  revival  of 
business  the  price  of  crude  rubber  is  certain  to  advance. 

The  valuation  was  probably  determined  by  the  inference  that 
sellers,  on  the  basis  of  replacement  costs,  would  refuse  to  sell  any 
considerable  quantity  at  less  than  the  cost  of  production.  In  the 
corporation's  semiannual  report  for  the  six  months  ended  June, 
30,  192 1,  the  following  statement  was  made: 

In  ascertaining  the  results  for  the  first  six  months  of  192 1,  the  cost  of 
goods  sold  was  computed  on  the  basis  of  the  cost  of  the  goods  carried  in 
inventory  as  of  the  first  of  the  year,  plus  the  cost  of  the  goods  manufactured 
during  the  period,  thus  absorbing  in  cost  any  depreciation  that  may  have 
occurred  in  inventory  after  the  first  of  the  year  and  also  the  higher  cost  of 
goods  manufactured  during  the  period.  The  cost  of  finished  goods  carried 
over  as  of  the  first  of  the  year  was  conservative  on  the  basis  of  the  selling 
prices  then  prevailing,  which  prices  it  was  believed  would  be  maintained 
for  the  period  of  time  necessary  to  effect  the  liquidation  of  stocks. 
Instead,  however,  it  was  found  necessary  to  substantially  reduce  selling 
prices  for  some  classes  of  merchandise,  especially  tires  and  mechanical 
goods.  The  effect  of  these  price  reductions  was  necessarily  reflected  in  the 
results  of  sales  for  the  first  six  months  of  this  year,  in  addition  to  which 
there  were  reflected  in  the  net  results  for  the  period  the  burdens  of  the 
higher  cost  of  goods  sold,  as  shown  above. 

It  is  obvious  from  the  foregoing  that  it  would  have  been  better 
on  December  31,  1920,  to  have  valued  the  crude  rubber  at  market 
instead  of  at  reproduction  cost. 

The  general  rule  may  be  stated  to  be  that  on  a  declining 
market,  inventories  should  be  valued  at  market  or  replacement 
prices  or  less,  even  though  such  prices  are  below  the  current  cost 
of  reproduction. 

There  may  be  exceptions  when  the  market  is  luiduly  depressed 
and  when  the  cost  of  reproduction  obviously  has  reached  bottom 
or  nearly  bottom.    The  auditor  in  such  cases  is  justified  in  cer- 


144  AUDITING— GENERAL  PRINCIPLES 

tifying  to  values  on  any  reasonable  basis  when  the  balance 
sheets  show  the  basis  used. 

4.  When  Is  It  Proper  to  Value  an  Inventory  at  Market,  Market 
Being  Higher  than  Cost? 

Conservatism  and  expediency  are  to  be  commended  at  all 
times,  and  are  useful  offsets  to  the  tendency  of  business  men  to 
fool  themselves — to  overstate  assets  and  profits  and  to  understate 
HabiHties  and  losses.  But  there  should  be  no  secrecy  about  con- 
servatism and  expediency.  If  book  profits  seem  to  be  unreal, 
expediency  may  appear  to  justify  the  writing  down  of  asset  values 
arbitrarily  or  the  setting  up  of  large  reserves,  in  which  case  the 
balance  sheets  should  exhibit  a  truthful  picture  of  what  has  been 
done.  If  there  is  no  intention  to  write  down  values  arbitrarily, 
and  if  balance  sheets  purport  to  exhibit  the  actual  values,  as 
nearly  as  can  be  determined,  of  all  assets  shown  therein,  it  is 
obvious  that  the  rule  of  "cost  or  market,  whichever  is  lower" 
renders  impossible  a  true  and  accurate  balance  sheet  whenever 
market  values  substantially  exceed  cost.  It  is  possible  to  be  con- 
servative and  at  the  same  time  prepare  a  balance  sheet  which 
will  disclose — not  hide — favorable  changes  in  market  values. 

Value,  Not  Cost,  Is  the  Inventory  Criterion. — It  is  not 
always  possible  to  secure  trustworthy  market  quotations  for  all 
or  some  part  of  an  inventory,  in  which  case  the  cost  of  the  various 
items  is  of  great  importance.  When  trustworthy  market  quota- 
tions can  be  secured  the  question  of  cost  is  subordinated.  When 
the  market  is  substantially  higher  than  cost,  errors  in  computing 
cost  cannot  do  any  great  harm.  When  the  market  is  lower  than 
cost,  the  substitution  of  market  values  for  cost  prices  requires  an 
adjustment  of  the  income  account,  but  errors  in  computing  costs 
are  automatically  corrected  in  the  adjustment. 

The  important  question  of  actual  value  includes  much  more 
than  an  inquiry  into  market  unit  prices.  In  securing  market 
quotations  it  is  customary  to  place  entirely  too  much  reliance  on 


INVENTORIES— GENERAL  PRINCIPLES  I45 

quotations  for  apparently  the  same  goods  or  materials  as  those 
in  the  inventory.  This  erroneous  practice  extends  to  basic  mate- 
rials as  well  as  to  less  salable  commodities.  There  may  be  a 
nominal  quotation  of  13  cents  a  pound  for  copper,  but,  if  one 
concern  has  100,000,000  pounds  of  it  and  another  concern  has 
100,000  pounds,  the  quotation  does  not  apply  with  the  same 
weight  to  each.  The  concern  with  50  tons  may  dispose  of  it  at 
13  cents,  but  on  a  dull  market  the  concern  with  50,000  tons  could 
not  possibly  dispose  of  it  at  13  cents. 

This  principle  must  be  carried  to  inventories  as  a  whole.  For 
instance,  there  must  be  some  reasonable  relation  between  the  four 
groups  into  which  inventories  are  usually  divided.  The  quantity 
of  raw  materials  may  be  excessive  or  insufficient  when  compared 
with  the  goods  in  process.  The  length  of  time  it  requires  to 
convert  raw  materials  into  finished  product  and  the  manufac- 
turing capacity  of  the  concerns  which  own  the  materials  are 
always  important  factors.  The  relation  of  the  goods  in  process 
to  raw  materials  is  of  about  equal  importance  to  the  relation  of 
goods  in  process  to  finished  goods.  There  may  be  an  overstock 
of  the  latter  which  will  be  increased  as  the  goods  in  process 
are  completed.  The  question  of  an  overstock  depends  on  the 
possible  outlet  for  the  product.  The  turnover  of  previous  periods 
is  usually  a  good  criterion,  but  only  under  normal  conditions. 
Likewise,  the  stock  of  supplies  may  be  out  of  proportion  to  the 
other  groups. 

Thus  it  is  seen  that  unit  cost  figures  and  unit  market  quota- 
tions are  only  two  out  of  at  least  twenty  factors  which  must  be 
considered  in  arriving  at  inventory  valuation^  for  balance  sheet 
purposes. 

It  has  been  stated  that  ''logically  considered,  books  of  account 
should  be  kept  so  as  to  reflect  cost  and  not  value  and  this  is  the 
theory  at  the  base  of  accounting  structure." '^  The  author 
beheves  that  the  foregoing  statement  is  inaccurate;  its  appHcation 
leads  to  self-deception  and  to  the  deception  of  others.  The  state- 
'7  Journal  of  Accountancy,  July,  192 1  (editorial),  page  50. 

VOL.  I — 10 


/ 


146  AUDITING— GENERAL  PRINCIPLES 

ment  should  read:  ''Books  of  account  should  be  kept  so  as  to 
record  original  cost;  at  regular  intervals,  and  always  when  balance 
sheets  are  prepared,  costs,  if  prices  have  changed,  should  be  ad- 
justed to  reflect  value."  Adjustments  of  fixed  assets  should 
ignore  mere  fluctuations  and  be  limited  to  depreciation,  depletion, 
and  obsolescence,  except  in  cases  of  changes  in  ownership  and  for 
similar  reasons;  adjustments  of  current  assets  should  reflect  fluc- 
tuations up  and  down  in  order  that  existing  values  be  reflected  in 
all  balance  sheets  and  similar  statements. 

""  There  is  no  general  rule  which  sanctions  the  marking  up  of 
inventories  to  market  prices.  When  an  auditor  desires  to  have  a 
balance  sheet  reflect  market  prices,  and  market  prices  exceed 
cost,  it  should  be  looked  upon  as  exceptional.  Preferably  the 
special  reason  for  such  action  should  appear  in  the  auditor's  cer- 
tificate and  the  amoimt  of  the  write  up  should  be  separately 
stated  as  part  of  the  inventory  item  as  well  as  a  separate  item  in 
surplus. 

American  Malting  Case. — In  this  case'^  the  court  held 
that  a  director  of  the  corporation  was  hable  in  money  damages 
arising  from  his  negligence  in  permitting  the  writing  up  of  values, 
anticipating  profits  on  unfilled  contracts,  and  paying  out  in  divi- 
dends such  prospective  profits.  The  profits  were  estimated  on 
deliveries  to  be  made  far  in  advance.  In  one  sense  of  the  word 
they  were  not  speculative  because  the  product  was  sold  under 
contract;  but  in  no  sense  of  the  word  were  the  profits  realized  at 
the  date  dividends  were  declared.  The  court  said:  ''These  con- 
tracts were  to  deliver  at  a  future  time  a  product  not  yet  made 
from  raw  material  not  yet  purchased,  with  the  aid  of  labor  not 
yet  expended."  Under  such  circumstances,  there  was  no  justifica- 
tion for  setting  up  any  profit,  contingent  or  realizable,  on  the 
books. 

The  court,  however,  drew  a  sharp  distinction  between  pro- 
spective profits  and  what  appeared  to  have  been  a  definitely  as- 


'8  Hutchinson  v.  Curtiss,  92  N.  Y.  S.  70  (1904);  45  Misc.  Rep.  484. 


INVENTORIES— GENERAL  PRINCIPLES  147 

certainable  increment  in  value  at  the  date  of  preparing  the  state- 
ments upon  which  the  dividends  were  based. 
The  court  said: 

Barley  is  bought  by  the  bushel  of  forty-eight  pounds.  Malt,  the  manu- 
factured article  made  from  barley  by  steeping,  is  dealt  in  by  the  bushel  of 
thirty-four  pounds.  The  process  of  manufacture  produces  about  fifteen 
per  cent  more  of  malt  by  the  bushel  than  the  barley  measures  from  which 
it  is  produced.  The  amount  of  this  fifteen  per  cent  excess  is  reported  from 
each  of  the  manufactories  month  by  month  as  increase.  Of  course,  this 
increase  has  a  value,  as  it  is  sold  as  malt  at  malt  prices.  For  the  purpose 
of  inventory  the  company  has  ascribed  to  it  the  value  of  the  barley.  This, 
plaintiff's  claim,  is  error,  because  that  amount  has  already  once  been 
charged  to  malt  account,  and  they  say  this  increase  should  have  no  value 
ascribed  to  it  until  sold  and  delivered,  when  its  proceeds  go  into  the  books 
as  cash.  But  it  certainly  is  an  asset  of  the  company,  and  as  an  asset  at 
inventory  periods,  or  when  it  is  necessary  to  ascertain  the  actual  condition 
of  the  company,  it  must  be  valued  in  some  way.  As  it  has  always  been 
the  custom  in  the  malting  business  to  treat  it  as  treated  by  this  company, 
I  am  unwilling  to  disregard  that  custom. 

The  court  evidently  took  the  position  that  a  correct  balance 
sheet  is  one  which  takes  into  account  values  accrued  (increment) 
to  the  date  of  a  financial  statement;  but  which  eliminates  any  . 
apparent  or  prospective  profit  to  be  thereafter  realized  from  the  i 
delivery  of  the  product  at  prices  in  excess  of  the  replacementjl 
(market)  value  at  the  date  of  the  balance  sheet. 

5.  When  Is  It  Proper  to  Value  an  Inventory  at  Selling  Prices? 

It  is  customary  to  condemn  unreservedly  the  practice  of  in- 
ventorying goods  or  commodities  at  selling  prices.  Certainly  it 
is  a  radical  departure  from  *'cost  or  market,  whichever  is  lower." 
So  the  question  arises,  "  Can  it  ever  be  good  accounting  practice?  " 
If  we  define  good  accounting  practice  to  be  that  which  is  followed 
by  good  accountants,  we  find  many  precedents  for  valuing 
inventories  at  selling  prices.  We  find  balance  sheets  of  well- 
managed  and  prosperous  concerns  certified  to  by  leading  account- 
ants, in  which  the  statement  appears  that  inventories  are  valued 


148  AUDITING— GENERAL  PRINCIPLES 

at  selling  prices.  Under  the  circumstances  we  are  forced  to  the 
conclusion  that  it  may  be  good  accounting  practice. 

Perhaps  the  test  always  lies  in  full  disclosure.  The  author 
contends  that  in  every  case  when  inventory  items  are  carried  on 
a  balance  sheet  without  explanatory  comment,  those  who  use  the 
balance  sheet  are  justified  in  assuming  that  no  profit  whatever 
appears  in  the  item,  and  that,  if  there  has  been  a  decline  in  values, 
the  decline  has  been  fully  reflected.  But  if  the  inventory  is 
clearly  shown  to  be  at  selling  prices,  the  chief  cause  for  criticism 
has  been  removed.  There  may  be  anticipation  of  profits  but  there 
is  no  deception.  If  there  is  a  good  reason  for  this  basis  of  value, 
the  other  objections  are  likewise  removed.  It  may  be  that  those 
responsible  for  the  operations  of  the  concerns  and  those  who  cer- 
tify to  the  accounts  are  convinced  that  a  true  statement  for  a 
specified  period  can  be  shown  only  by  recording  as  completed 
those  transactions  which,  according  to  the  best  information  at  the 
date  of  the  balance  sheet,  were  completed. 

The  following  examples  have  been  noted  wherein  inventories 
have  been  stated  to  be  at  selling  prices  when  such  prices  have  been 
in  excess  of  cost: 

Mining  Companies — gold,  silver,  copper,  lead,  and  other 

metals. 
Packing  Companies — fresh  meats  and  other  products. 
Oil  Companies — crude  oil  and  refined  products. 
Sugar  Companies — sugar  and  molasses. 

In  some  cases,  but  not  all,  firm  orders  were  in  hand  for  the 
entire  inventory  priced  at  selling  values. 

It  has  not  always  so  appeared,  but  it  is  believed  that  in  all 
cases  the  items  were  net  of  selling  and  delivery  expenses  and 
charges.  It  has  been  pointed  out  that  in  many  cases  loans  are 
made  on  commodities  at  prices  in  excess  of  cost  and  that  it  would 
be  improper  to  show  a  liability  on  one  side  of  a  balance  sheet 
greater  than  the  book  value  of  the  specific  commodity  on  which 
the  loans  were  based. 


INVENTORIES— GENERAL  PRINCIPLES  I49 

The  author  does  not  know  of  any  authority  which  contends 
that  profits  accrued  only  upon  realization  in  cash  of  the  proceeds 
of  sales.  Under  existing  general  practice  the  conversion  of  mer- 
chandise into  accounts  receivable  marks  the  point  when  profits 
may  be  taken.  When  we  analyze  this  practice  we  find  that  it  is 
conservative  but  not  logical.  If  we  are  simply  trying  to  establish 
standards  which  rest  solely  on  conservatism,  we  do  not  go  far 
enough  in  estabHshing  reserves  for  doubtful  accounts. 

A  mining  company  may  sell  copper  to  B  on  December  i,  1920. 
B  is  reported,  prior  to  December  31 ,  to  be  a  poor  risk,  so  a  reserve 
is  set  up  to  provide  for  the  prospective  loss.  The  Treasury  says: 
''You  have  realized  a  taxable  profit  but  you  have  not  realized  a 
loss;  you  must  pay  a  tax  on  the  profit."  On  December  31  the 
company  had  on  hand  copper  sold,  but  not  shipped,  to  the  Stand- 
ard Oil  Company.  If  it  inventoried  the  copper  at  selling  price  the 
Treasury  would  say:  "You  have  not  realized  the  profit  and  you 
should  not  report  the  profit. "  The  facts  of  the  case  are  that  from 
a  common-sense  business  point  of  view  the  sale  to  B  resulted  in  a 
loss  and  the  sale  to  the  Standard  Oil  Company  resulted  in  a  profit 
prior  to  December  ji.  In  many  cases  accounts  receivable  are 
never  converted  into  cash  even  though  they  appear  to  be  good,"* 
and  in  countless  cases  collections  are  spread  over  a  period  of  six 
months  or  a  year. 

Why  should  good  accounting  practice  blindly  accept  delivery 
of  goods  and  transfer  of  title  as  equivalent  to  realization,  and 
refuse  to  sanction  as  good  accounting  practice  the  taking  up  of 
profits  on  orders  which  will  be  converted  into  cash  long  before 
many  of  the  accounts  receivable  will  be  collected?  If  the  only 
defense  is  expediency  and  conservatism,  the  author  agrees  that 
the  defense  is  good  and  almost  sufficient.  If  the  answer  is  that 
the  practice  is  logical  or  that  it  truly  exhibits  actual  results  for  a 
specific  period,  the  author  contends  that  it  is  not  logical  and  that 
it  obscures  actual  results.  It  may  be  that  few  concerns  can  qual- 
ify under  the  strict  requirements  which  the  policy  of  inventorying 
'9  See  page  91. 


150  AUDITING— GENERAL  PRINCIPLES 

at  sales  price  contemplates,  viz.,  basic  commodities  for  which 
there  is  a  continuous  demand;  complete  publicity;  uniformity 
over  a  period  of  years ;  unquestioned  recognition  of  their  obliga- 
tions by  customers  or  vendees  (industries  in  which  cancellations 
occur  are  barred  as  a  matter  of  course). 

The  truth  of  the  matter  is  that  thousands  of  concerns  which 
have  prided  themselves  on  not  anticipating  profits  have  habitu- 
ally been  guilty  of  far  less  conservative  practice  in  overvaluing 
the  unsold  portions  of  inventories.  As  stated  elsewhere,  the 
results  of  the  last  few  years  have  demonstrated  that  the  word 
''market"  is  grossly  deceptive.  It  would  be  far  better  to  value 
sold  goods  at  sales  prices  and  unsold  goods  at  far  less  than  cost 
or  so-called  market,  than  to  price  entire  inventories  at  inflated 
values,  and  thus  in  effect  fail  to  anticipate  losses. 
''^  The  author  has  reached  the  conclusion  that  good  accounting 
practice  permits  inventories  represented  by  firm  orders  from 
solvent  and  honorable  payers,  verified  by  actual  experience  (at 
least  in  part)  after  the  date  of  the  balance  sheet,  to  be  priced 
at  net  sales  prices,  when  no  one  is  deceived  and  when  good  busi- 
ness judgment  sanctions  the  practice  as  exhibiting  the  true  results 
of  operations  for  a  specified  period,  always  assuming  that  the 
accounts  are  so  stated  that  the  exact  facts  are  clear  to  all  who  use 
the  balance  sheets;  that  the  practice  is  optional,  and  that  it  is 
designed,  only  to  reflect  *'true  financial  conditions."  When  all 
of  these  conditions  are  observed,  the  rule,  "cost  or  market, 
whichever  is  lower,"  has  no  relevancy. 

The  foregoing  rule,  however,  is  effective  only  when  all  parts 
of  inventories  not  valued  at  sales  priced  are  ruthlessly  reduced  to 
actual  market  prices  if  not  worth  cost,  and  when  "market"  is 
construed  to  mean  the  prices  at  which  one  would  willingly  buy 
equal  quantities  of  exactly  similar  goods. 

Prices  After  Closing  Date 

The  fundamental  error  in  the  rule  of  "cost  or  market,  which- 
ever is  lower,"  is  the  distinction  made  between  inventory  values 


INVENTOR  FES— GENERAL  PRINCIPLES  151 

and  accounts  receivable.  Any  appreciation  in  the  value  of  unsold 
goods,  no  matter  how  permanent  and  no  matter  how  near  to 
actual  realization,  is  ignored  on  the  balance  sheet;  yet  the  instant 
an  account  receivable  is  created  the  full  profit  is  taken  The  old 
rule  should  be  most  effective  in  a  period  of  inflation,  but  that  is 
when  it  is  least  effective.  During  1920  the  quantity  and  value  of 
returned  goods  were  very  large,  thus  indicating  that  accounts  re- 
ceivable may  be  of  no  more  actual  value  than  orders  and  contracts. 
The  author  is  not  attacking  the  rule  from  its  conservative 
side  but  calls  attention  to  its  unscientific  features.  The  balance 
sheet  which  reflects  permanent  appreciation  in  the  value  of  cur- 
rent assets  is  more  accurate  than  the  balance  sheet  which  fails 
to  make  provision  for  goods  which  may  be  returned.  The 
answer  usually  made  in  the  latter  case  is  that,  since  a  balance 
sheet  frequently  is  not  certified  to  until  several  months  after  the 
closing  date,  the  value  of  the  accounts  receivable  as  of  a  past  date 
can  be  checked  on  the  basis  of  collections  or  returns  during  the 
interval.  True,  but  it  is  even  more  true  of  stocks  of  goods  on 
hand  at  the  closing  date.  Under  the  rule  such  subsequent  fluctua- 
tions are  largely  or  wholly  ignored.  Is  it  not  better  to  take  cog- 
nizance of  transactions  which  occur  subsequent  to  the  closing 
date?  When  orders  in  hand  are  filled  and  the  profit  is  realized, 
why  not  show  at  least  part  of  the  profit  in  the  period  during  which 
the  orders  were  taken  and  the  goods  purchased  or  manufactured? 
The  profit  should  not  be  merged  with  realized  profit,  but  should 
show  in  a  separate  item  in  the  surplus  account,  and  as  a  separate 
item  in  the  balance  sheet.  The  proper  objections  to  anticipating 
a  profit  are  thus  obviated.  If  there  is  a  decline  in  market  prices 
subsequent  to  the  closing  date,  why  not  assume  that  the  causes  of 
the  decline  had  their  inception  in  the  period  prior  to  the  closing 
date,  and  accordingly  write  down  the  inventory  to  lower  values 
than  the  nominal  quotations  as  at  the  date  of  closing  appear  to 
justify?  And  if  there  is  a  rise  in  market  prices  after  the  closing 
date,  why  not  assume  that  the  causes  of  the  rise  had  their  incep- 
tion prior  to  the  closing  date  and  therefore  carry  the  inventories 


152  AUDITING— GENERAL  PRINCIPLES 

at,  let  us  say,  cost  of  production  even  though  the  nominal  market 
quotations  were  lower  than  cost?  Why  proceed  as  if  there  were 
something  sacred  in  the  purely  temporary  conditions  which  fre- 
quently exist  on  the  closing  date  of  a  fiscal  year?  Any  school 
boy  knows  that  important  changes  in  trade  conditions  do  not 
occur  in  a  single  day. 

Why  should  there  be  a  radical  difference  in  the  income  state- 
ments of  three  concerns  engaged  in  the  same  kind  of  business, 
merely  because  their  fiscal  years  end  November  30,  December  31, 
and  January  3 1 ,  respectively?  All  are  affected  equally  by  an  up- 
ward or  downward  trend  in  prices;  yet  the  balance  sheets  of  these 
three  concerns,  prepared  in  1920  and  192 1  under  the  old  rule, 
differ  widely  because  published  quotations  showing  radical 
changes  in  prices  make  it  appear  that  the  changes  similarly  affect 
values.  It  is  a  fact  that  two  out  of  the  three  are  not  truthful 
balance  sheets;  instead  of  reflecting  facts  they  ignore  facts. 
What  is  more  concrete  than  a  definite  trend  in  an  industry?  Raw 
materials  go  up  or  down  in  price  because  of  changes  in  financial 
and  labor  conditions;  these  influences  permeate  the  distributing 
and  manufacturing  sections  of  industry,  and  sooner  or  later  retail 
prices  are  affected.  Such  fundamental  movements  do  not  pro- 
duce their  full  effect  in  a  period  of  one  or  two  months.  The  aver- 
age business  man  is  able  merely  to  guess  when  the  peak  of  prices 
or  the  point  of  lowest  depression  will  be  reached,  but  the  trend  is 
usually  unmistakable.  As  all  inventory  values  are  matters  of 
opinion,  there  is  no  good  reason  why  an  actual  trend  should  not 
be  reflected,  rather  than  to  refuse  to  adjust  values  on  the  ground 
that  the  fluctuations  are  not  permanent. 

Interdepartmental  or  Intercompany  Profits 

In  the  case  of  large  enterprises  where  the  article  which  is  fi- 
nally sold  to  the  public  passes  through  several  departments  or 
through  several  companies  whose  assets  will  be  included  in  a 
final  balance  sheet,  it  is  very  important  that  any  profits  which 
have  been  included  in  their  figures  by  the  departments  or  com- 


INVENTORIES—GENERAL  PRINCIPLES  153 

panics  when  billing  the  product  to  other  departments  or  com- 
panies, should  be  eliminated  from  the  inventory  prices.  If  it  is 
not  possible  to  get  such  actual  profit  figures,  an  estimated  reserve 
should  be  provided,  based  on  the  best  information  obtainable  to 
exclude  the  approximate  amount  of  profits  in  sales  price  which 
has  accrued  to  the  department  or  subsidiary  selling  the  same  or 
furnishing  service  in  connection  therewith.''** 

Segregation  of  Stock  Which  Cannot  Be  Converted  into  Cash 
Within  One  Year 
In  discussing  accounts  receivable  it  was  pointed  out^^  that 
accounts  not  due  within  one  year  should  not  be  classed  as  current 
assets  unless  the  accounts  receivable  of  an  industry  as  a  whole  are 
known  to  mature  over  a  longer  period.  The  author  has  found  no 
such  restriction  on  inventory  valuations.  Deeds  of  trust  which 
carefully  provide  that  accounts  receivable  are  not  current  assets 
unless  due  within  one  year,  place  no  limitation  on  the  conversion 
period  of  inventories.  There  does  not  seem  to  be  any  good  reason 
why  inventories  should  not  be  segregated  into  classes  depending 
on  reasonable  estimates  as  to  when  they  will  be  converted  into 
accounts  receivable  or  cash.  It  would  be  a  shock  to  some  credit 
grantors  if  they  were  to  receive  carefully  prepared  estimates  of 
the  earliest  dates  by  which  certain  parts  of  inventories  could  be 
disposed  of.  Some  concerns  manufacturing  machinery  for  which 
repair  parts  are  supplied  carry  unnecessarily  large  stocks  of  such 
parts.  In  some  cases  a  ten-year  supply  is  carried.  Is  it  proper  to 
carry  the  valuation  of  stock  which  at  the  earliest  will  not  be  dis- 
posed of  for  ten  years  as  a  current  asset?  The  author  thinks  not, 
and  advocates  the  segregation  of  inventories  into  two  classes,  one 
which  may  reasonably  be  expected  to  be  converted  into  accounts 
receivable  or  cash  within  one  year,  and  the  other  representing 
realizations  beyond  one  year.  For  the  present  it  is  good  account- 
ing practice  to  include  both  classes  of  inventories  as  current 


20  For  further  discussion  of  this  point,  see  page  317. 

21  See  page  lOO. 


154  AUDITING— GENERAL  PRINCIPLES 

assets,  but  after  a  sufficient  number  of  concerns  make  the  segrega- 
tion it  may  be  expected  that  custom  will  demand  that  class  num- 
ber two  be  transferred  to  the  fixed  assets  group. 

Auditor's  Legal  Duty  as  to  Inventories 

In  a  celebrated  English  case^^  it  is  held  by  the  court  that  an 
auditor  is  not  a  valuer;  that  it  is  not  his  duty  to  take  stock;  that 
in  the  absence  of  suspicious  circumstances  he  is  entitled  to  rely 
upon  the  representations  of  responsible  officials;  and  that  he  is 
not  guilty  of  negligence  if  he  accepts  the  certificate  of  such  per- 
sons to  the  value  of  the  stock-in-trade. 

The  auditor's  course,  therefore,  is  to  secure  all  the  evidence 
within  his  power  to  demand,  and,  lacking  any  part  of  the  proof 
which  he  deems  necessary,  his  only  course  is  to  qualify  his  certifi- 
cate accordingly. 

The  author  thinks  that  accountants  in  England  rely  too  much 
on  the  decision  of  a  Lord  Chief  Justice  to  the  effect  that  the  audi- 
tor *'  is  not  called  upon  to  be  suspicious,  nor  even  to  make  inquiry, 
provided  that  nothing  comes  to  his  notice  to  cause  him  to  think 
that  there  is  need.  "^^  This  may  be  law,  but  it  is  a  poor  rule  to 
insert  in  an  audit  program. 

It  may  be  that  the  borrowers  and  debtors  in  the  United  States 
overstate  their  inventories  and  deceive  their  creditors  to  a  greater 
extent  than  is  the  case  in  England.  If  so,  an  auditor  there  may  be 
justified  in  accepting  the  certificate  of  someone  else  as  the  sole 
check  on  the  stock,  but  an  auditor  here  who  desires  to  acquire  a 
reputation  for  dependability  should  not  be  content  with  this 
measure  of  his  duty. 

Is  it  not  true  that  the  stockholder  or  banker  is  being  taught  to 
look  on  the  professional  auditor  as  a  sort  of  watchdog — one  who 
detects  all  irregularities,  insists  on  businesslike  methods,  sees  that 
the  accounts  are  stated  clearly  and  correctly,  and  prevents 
unsatisfactory  conditions  generally? 


^2  /n  re  Kingston  Cotton  Mill  Co.,  2  Ch.  Div.  279  (1896). 
"3  Ibid. 


INVENTORIES— GENERAL  PRINCIPLES  155 

Now  what  more  important  element  of  business  is  there  than 
"  stock-taking  "  ?  Is  it  not  the  most  important  of  all?  On  it  may 
depend  financial  success  or  failure;  on  it  dividends  may  be  paid  or 
passed.  Is  it  not,  then,  in  every  sense  of  the  word,  a  financial 
transaction  to  be  audited? 

The  English  law  says  that  the  auditor  is  using  reasonable  care 
and  skill  when  he  accepts  the  certificate  of  a  responsible  official. 
The  profession  will  not  advance  in  usefulness  and  standing  if  this 
is  to  be  the  standard  on  this  side  of  the  Atlantic. 

The  author  differs  from  those  who  maintain  that  an  auditor, 
not  being  a  valuer,  has  no  right  to  attempt  to  pass  upon  physical 
valuations,  including  stock-in-trade  and  plant;  his  opinion  is  that 
an  auditor's  duty  is  not  properly  performed  unless  he  does  all 
that  his  experience  and  skill  enable  him  to  do. 

Numerous  instances  may  be  cited  in  which  professional  audi- 
tors, without  any  special  knowledge  whatever  in  particular  lines 
of  business,  have  detected  overvaluations,  excessive  statements  of 
quantities,  and  misstatements  as  to  the  condition  of  the  stocks. 
Some  of  these  discoveries  are  of  sufficient  importance  to  stop  the 
sale  of  a  business  or  the  extension  of  a  line  of  credit  by  a  banker. 

In  many  of  these  cases  the  inclusion  in  the  certificate,  by  the 
auditor,  of  a  statement  to  the  effect  that  he  has  accepted  the 
inventory  valuations  without  verification,  would  have  been 
acceptable  to  his  client  at  the  time,  but  subsequent  events  would 
have  demonstrated  the  worthlessness  of  the  report  from  a  prac- 
tical point  of  view. 

Looking  at  it  from  another  angle,  it  may  be  asked :  Why  not 
as  well  accept  a  certificate  from  the  cashier  to  the  effect  that  the 
cash  balance  is  duly  accounted  for,  as  accept  the  certificate  of  the 
stockkeeper  to  the  effect  that  the  materials  and  goods  under  his 
care  are  on  hand? 

Interest  Not  an  Element  of  Cost 

The  question  whether  or  not  interest  on  capital  invested  in 
plant  is  an  element  of  the  manufacturing  cost  of  goods,  has  been 


156  AUDITING— -GENERAL  PRINCIPLES 

fully  debated  by  accountants  and  economists.  Those  interested 
in  the  arguments  used  on  both  sides  of  the  question  should  con- 
sult the  volumes  of  the  Journal  of  Accountancy.^^  The  author 
takes  the  definite  position  that  it  is  fallacious  to  treat  it  as  an 
element  of  cost. 

Apart  from  other  and  good  reasons,  the  fundamental  difficul- 
ties involved  in  the  attempt  to  standardize  the  interest  charge  are 
so  great  as  to  prove  the  weakness  of  the  argument.  Interest  rates 
and  the  actual  cost  of  invested  capital  vary  to  a  marked  degree. 
For  example,  if  the  capital  of  one  concern  is  secured  by  the  sale 
of  common  stock  at  par,  and  that  of  another  by  sale  of  an  8  per 
cent  preferred  stock  at  90,  redeemable  at  125,  what  interest  rates, 
respectively,  should  be  used?  These  examples  are  not  extreme; 
they  are  fairly  typical  of  corporate  financing. 

A  fixed,  or  arbitary,  rate  cannot  be  used,  since  it  is  neither  fish 
nor  fowl.  The  proponents  are  sadly  at  sea  as  to  details.  Is 
interest  (if  the  rate  be  found)  to  be  calculated  on  the  cost  or  value 
of  land,  buildings,  and  equipment;  on  tools  and  fixtures;  on  raw 
materials  and  goods  in  process;  or,  as  has  been  suggested  face- 
tiously, on  wages  from  time  of  payment  to  time  of  completion? 
If  charged  into  costs,  what  corresponding  credit  is  to  be  made? 
If  to  income,  it  might  easily  result  in  a  new  concern  showing 
a  handsome  profit  from  manufacturing  before  a  dollar's  worth 
of  goods  is  sold. 

It  is  argued  that  there  is  no  difficulty  in  determining  a  rate, 
because  the  only  basis  is  the  rate  which  the  owner  could  obtain 
upon  his  capital  if  securely  loaned  instead  of  being  invested  in  his 
own  business.  Not  many  years  ago  good  4  per  cent  bonds  sold 
above  par;  today  the  same  bonds  sell  at  not  much  more  than  half 
the  former  prices.  The  term  "securely  loaned  "  is  too  vague  to  be 
used  as  an  important  element  in  determining  the  cost  of  produc- 
tion.    It  is  never  denied  that  accurate  costs  are  valuable  for 


24  Consult  also  the  Accountants^  Index  and  the  bibliography  given  in  the 
American  Economic  Review,  Vol.  x,  No.  3,  pages  562-3.  Also  consult  papers 
and  discussions,  Convention  of  the  National  Association  of  Cost  Accountants, 
September,  1921. 


INVENTORIES— GENERAL  PRINCIPLES  I57 

comparative  purposes;  but  how  many  business  men  agree  on  an 
interest  rate  for  money  "  securely  loaned  "?  If  they  do  not  agree 
and  a  speculative  and  fluctuating  element  is  introduced,  the  value 
of  comparison  is  greatly  lessened. 

Important  reasons  for  determining  the  cost  of  goods  are  the 
need  of  solving  inventory  problems  and  of  establishing  sales  prices. 
In  the  former  case  the  inclusion  of  interest  results  in  padding  the 
inventory  and,  if  approved  by  an  auditor,  justly  subjects  him  to 
criticism  by  bankers.  In  the  latter  case  no  substantial  benefit  is 
secured.  Intelligent  manufacturers,  in  fixing  the  selling  prices  of 
goods,  if  not  wholly  governed  by  the  prices  established  by  com- 
petition, give  due  consideration  to  all  costs  other  than  manufac- 
turing, such  as  administrative  and  sales  expenses.  They  can  be 
depended  upon  to  consider  the  possible  return  upon  invested  capi- 
tal, either  as  a  specific  rate  which  they  desire  to  earn  or  as  ''all 
the  traffic  will  bear. "  If  a  specific  rate  is  in  mind  in  a  manufactur- 
ing business,  it  can  hardly  be  less  than  12  or  15  per  cent  per  an- 
num ;  it  is  not  likely  that  any  manufacturer  will  include  such  a 
rate  as  part  of  manufacturing  cost. 

All  costs,  properly  calculated,  include  a  provision  for  the  up- 
keep and  renewal  of  the  plant.  Anything  beyond  this  must  be  an 
earning  or  profit  arising  out  of  the  use  of  the  plant.  It  is  true  that 
modern  conditions  seem  to  force  a  constant  increase  in  plant  in- 
vestment, frequently  out  of  proportion  to  increased  output. 
This  tendency,  however,  cannot  be  overlooked,  because  there  is  a 
corresponding  increase  in  depreciation  charges,  in  addition  to 
increased  capital  investment  upon  which  a  remunerative  return 
is  expected. 

It  is  not  a  good  argument  that  a  manufacturer  must  be  urged 
to  include  interest  as  a  factor  of  operating  cost,  because  otherwise 
he  will  not  realize  that  goods  produced  by  the  use  of  expensive 
machinery  may  actually  cost  as  much,  or  more,  as  goods  produced 
by  hand  labor.  It  is  inconceivable  that  a  manufacturer  who  must 
constantly  weigh  the  advantages  and  disadvantages  of  various 
methods  of  production,  can  remain  ignorant  of  the  fact  that 


158  AUDITING— GENERAL  PRINCIPLES 

machinery  costs  money,  must  be  maintained  and  renewed,  and 
that  the  sales  price  of  his  product  should  include  an  adequate 
return  upon  the  capital  invested. 

It  is  unsound  argument  to  say  that  interest  on  the  investment 
must  be  earned.  Unfortunately,  manufacturers  do  not  always 
realize  sufficient  profit  to  equal  a  fair  rate  on  their  investment. 
It  is  absurd  to  charge,  say,  6  per  cent  interest  on  capital  as  an 
element  of  manufacturing  cost,  and  then  in  the  income  account 
show  a  loss  equal  to  3  per  cent.  Such  books  are  erroneous. 
Actually  the  plant  has  earned  3  per  cent  net  on  the  investment; 
it  has  not  earned  part  and  lost  part.  It  is  synonymous  with 
partners'  salaries.  A  partner  acting  as  superintendent  of  a 
factory,  who  includes  in  the  pay-roll  a  weekly  allowance  of  $100 
to  himself  and  charges  it  as  a  factor  of  manufacturing  cost,  de- 
ceives himself  if  he  thinks  the  factory  must  stand  it.  If  the  final 
result  for  the  year  shows  his  share  of  the  profits  to  be  $2,600,  after 
treating  the  *' salary"  as  an  expense,  mere  bookkeeping  entries 
cannot  obscure  the  actual  result,  i.e.,  that  he  has  realized  $7,800 
for  the  year. 

For  an  interesting  legal  decision  supporting  the  contention 
that  interest  on  capital  invested  in  a  business  is  not  an  element  of 
cost,  see  the  Journal  of  Accountancy  (Vol.  XVI,  page  145)  and 
other  cases  cited  therein. 


CHAPTER  IX 

INVENTORIES— RULES  FOR  VALUATION 

In  the  preceding  chapter,  the  principles  involved  in  the  valua- 
tion of  inventories  have  been  discussed.  It  has  been  shown  that 
the  old  rule  of  ''cost  or  market,  whichever  is  lower,"  is  not  trust- 
worthy in  a  period  of  violent  fluctuations  and  when  there  is  no 
agreement  as  to  the  definitions  of  the  words  ''cost"  and  "mar- 
ket." In  this  chapter  the  author  suggests  a  more  comprehensive 
general  rule,  followed  by  specific  rules  for  verifying  quantities, 
quality,  and  other  elements  almost  as  important  and  necessary 
as  the  element  of  valuation. 

Proper  Rule  for  Valuation 

Inventories  should  be  valued  at  cost  or  market  prices  when 
there  have  been  no  substantial  fluctuations  in  selling  prices  or 
costs  during  the  preceding  fiscal  period  and  in  so  far  as  the  results 
fairly  reflect  conservative  values  for  balance  sheet  purposes.  It 
is  obvious  that  in  normal  times  cost  and  market  prices  are  prac- 
tically the  same;  the  term  "market"  is  synonymous  with  re- 
placement cost;  therefore,  when  there  have  been  no  radical  fluc- 
tuations in  values  or  methods,  original  cost  and  replacement  cost 
are  the  same,  or  so  nearly  the  same  that  the  rule  of  "cost  or  market, 
whichever  is  lower,"  is  a  satisfactory  one  and  does  not  deceive 
those  who  use  balance  sheets.  When  some  other  method  is  re- 
quired to  produce  fair  values  for  balance  sheet  purposes,  good 
accounting  practice  sanctions  the  substitution  of  one  of  the  follow- 
ing methods : 

I.  It  is  proper  to  value  inventories,  or  portions  thereof,  at 
more  than  cost  and  in  some  relation  to  net  sales  prices,  when : 

(a)  Costs  are  difficult  to  determine  due  to  inherent  difficulties, 
such  as  occur  when  several  commodities  are  produced  from  one 

159 


l6o  AUDITING— GENERAL  PRINCIPLES 

process,  or  due  to  accounting  difficulties  which  occur  when  raw 
materials  are  bought  at  widely  fluctuating  prices,  etc. 

(b)  Costs  are  substantially  below  replacement  costs. 

(c)  Firm  sales  have  been  made  and  cancellations  are  definitely 
deemed  to  be  improbable,  whether  or  not  market  prices  are  ad- 
vancing. 

In  (a),  (b),  and  (c)  the  unrealized  profits  and  the  asset  ac- 
counts arising  therefrom  must  be  separately  stated  in  the  income 
account  and  in  the  balance  sheet.  If  it  is  not  deemed  to  be 
desirable  to  show  the  segregation,  the  auditor  should  refuse  to 
certify  to  the  balance  sheet.  Without  segregation  it  is  assumed 
that  the  usual  rule  of  "cost  or  market,  whichever  is  lower,"  has 
been  observed. 

In  (a)  and  (b)  proper  consideration  must  be  given  to  the 
operations  of  the  succeeding  period  which  should  be  permitted  to 
realize  a  reasonable  profit  from  handling  the  inventory.  When 
the  book  cost  of  producing  copper  is  12  cents  a  poimd  and  the 
market  price  is  24  cents,  it  would  be  proper  to  inventory  unsold 
copper,  say,  at  18  cents.  This  method  roughly  divides  the  profit 
into  two  parts:  first,  the  increment  in  value  which  has  definitely 
accrued  before  the  date  of  the  balance  sheet,  and  second,  the 
profit  which  any  business  should  realize  from  sales.  In  all  cases 
the  balance  sheet  should  contain  understandable  explanations  of 
the  method.  The  clearest  method  is  to  show  inventory  at  cost 
in  one  item  and  increment  in  value  in  a  separate  item. 

In  (c)  a  higher  basis  of  valuation  may  be  allowed  than  in  (a) 
and  (b).  The  part  of  the  inventory  which  is  sold  and  which  good 
judgment  justifies  treating  as  finally  sold,  is  more  accurately  to  be 
compared  with  accounts  receivable  than  with  unsold  goods; 
therefore  the  succeeding  period  is  not  necessarily  entitled  to  the 
full  profit  on  sales  which  it  has  no  part  in  closing.  Copper  which 
costs  12  cents  and  is  sold  for  24  cents  a  pound  may  be  inventoried 
at,  say,  22  cents  a  pound  if  2  cents  a  pound  is  ample  to  cover  all 
expenses  (including  overhead)  to  time  of  collection  of  the  pro- 
ceeds. 


INVENTORIES— RULES  FOR  VALUATION  l6l 

2.  It  is  proper  to  value  inventories,  or  portions  thereof,  at 
less  than  cost  or  market,  when : 

There  is  what  is  believed  to  be  inflation  of  current  or  replace- 
ment costs.  The  balance  sheet  must  show  the  basis  of  valuation, 
which  presumably  will  be  an  estimated  past  or  future  replaceable 
value  as  distinguished  from  temporary  costs.  ^ 

3.  It  is  proper  to  value  inventories  at  cost,  even  though  cost 
is  higher  than  market,  when : 

(a)  Basic  commodities  or  staple  goods  are  temporarily  quoted 
at  less  than  the  fair  costs  of  production.  This  exception  must  be 
strictly  construed.  There  must  be  an  honest  belief  that  the  de- 
cline below  cost  of  production  is  only  temporary.  Even  then  it  is 
easy  to  make  mistakes.  It  is  permissible  to  assume  that  basic 
materials  never  remain  below  cost  of  production  for  any  extended 
period  of  time;  but  costs  of  production  also  decrease.  The  latter 
factor  must  not  be  ignored. 

(b)  Raw  materials  or  other  goods  have  been  purchased  at 
higher  prices  than  those  existing  at  the  date  of  closing,  and  such 
purchases  are  allocated  to  contracts  or  orders  which  are  not  sub- 
ject to  cancellation,  the  contract  or  sales  prices  of  which  are  based 
upon  the  high  cost  of  such  raw  materials. 

In  both  of  cases  3  (a)  and  (b)  the  balance  sheet  must  show  the 
basis  used.  Apparent  market  prices  are  ignored  in  both  instances, 
but  there  must  be  some  relation  to  actual  values,  or  else  the  me- 
thod is  not  justified.  If  what  is  believed  to  be  a  temporary 
decline  merges  into  a  permanent  decline,  the  basis  of  valuation 
will  prove  to  be  erroneous.  Therefore,  the  method  is  somewhat 
dangerous  and  may  be  used  only  when  it  is  boldly  shown  on  the 
balance  sheet  so  that  no  one  is  deceived.  If  the  valuation  is  justi- 
fied as  of  the  time  it  was  made,  no  blame  attaches  to  those  who 
fixed  the  values.  If  there  was  not  sufficient  justification  for  the 
valuation,  those  who  used  bad  judgment  must  assume  the  re- 
sponsibility.   The  usual  reason  given  for  not  reducing  inventories 

^  An  example  of  this  will  be  found  in  the  United  States  Steel  balance  sheet 
as  of  December  31,  1920.    See  page  125. 

VOL.  I — 1 1 


I62  AUDITING— GENERAL  PRINCIPLES 

of  basic  materials  to  apparent  lower  market  prices,  is  that  large 
quantities  cannot  be  purchased  at  less  than  cost  of  production. 
The  reason  fails  if  it  is  probable  that  large  quantities  can  be 
purchased  at  the  lower  prices.  When  apparent  market  prices  are 
not  considered  to  be  representative,  the  basis  suggested  in  effect 
substitutes  real  market  prices  which  are  assumed  to  be  reproduc- 
tion or  replacement  costs. 

Rules  for  Verifying  Quantities  and  Other  Factors 

The  author  has  compiled  some  simple  directions  for  use  by 
those  who  desire  to  make  a  real  test  of  the  item  which  frequently 
is  the  largest  in  a  balance  sheet.  If  these  are  followed  with  care, 
and  the  auditor  has  given  careful  consideration  to  the  general 
principles  discussed  in  the  preceding  chapter,  he  need  not  hesitate 
to  certify  to  the  accuracy  of  the  inventory  item  in  the  balance  sheet. 

These  rules  rest  upon  the  assumption  that,  since  an  auditor  is 
not  a  valuer,  he  is  not  charged  with  a  special  or  technical  knowl- 
edge of  the  elements  surrounding  stock-in-trade;  so  that  if  he 
exercises  due  care  and  skill  he  may  feel  that  he  has  conscientiously 
discharged  the  duties  imposed  upon  him.  They  are  submitted  as 
a  guide  to  the  auditor,  who  desires  to  do  everything  reasonably 
possible  to  inform  his  clients  as  to  the  exact  condition  of  the  busi- 
ness under  examination. 

1 .  Ascertain  whether  all  of  the  items  included  in  the  inventory 
are  owned  by,  and  are  under  the  control  of,  the  concern  under 
audit.  Stocks  are  often  hypothecated,  and,  if  so,  the  fact  must 
be  stated  in  the  balance  sheet. 

2.  Secure  the  original  stock  sheets,  no  matter  how  rough  or 
soiled  they  may  be.  Decline  to  accept  ''fair"  copies  unless  the 
originals  have  been  destroyed,  in  which  case  consider  that  a  prima 
facie  case  of  concealment  has  been  made  out  and  require  strong 
affirmative  proof  to  account  for  the  missing  records. 

3.  If  not  certified  to  or  initialed  by  the  persons  who  took  the 
stock,  by  the  persons  who  made  the  calculations  and  the  footings, 
and  by  those  who  fixed  the  prices,  have  this  information  supplied 


INVENTORIES— RULES  FOR  VALUATION  163 

and  ascertain  that  the  persons  who  made  the  certificates  or  who 
supply  the  information  are  trustworthy  and  take  the  matter 
seriously.  Insist  on  a  clear  and  detailed  statement  in  writing  as  to 
the  method  followed  in.  taking  and  pricing  the  stock. 

4.  Test  the  calculations,  including  all  large  items,  and  prove 
the  footings.  The- term  ^4arge  items"  includes  quantity,  prices 
and  total  amounts.  If  the  inventory  is  a  very  extensive  one  and 
is  made  up  largely  of  small  items,  prove  the  footings  by  sight, 
i.e.,  foot  a  page  or  two  and  use  the  totals  of  those  pages  as  a 
mental  guide  in  looking  over  the  other  pages.  Many  instances 
have  been  found  where  serious  errors  have  been  made  both  in 
calculations  and  footings,  so  that  an  auditor  who  fails  to  cover  this 
point  is  open  to  criticism.  While  verifying  the  arithmetical  accu- 
racy, care  should  be  taken  to  make  sure  that  the  units  are  stated 
pu*operly,  that  is,  that  dozens  are  not  taken  for  gross,  etc.,  or  that 
prices  per  hundred  or  per  thousand  are  not  applied  as  unit  costs. 

5.  Where  stock  records  of  prices  and  quantities,  or  of  either, 
are  kept,  compare  the  totals  of  the  physical  inventory  with  the 
book  figures  and  trace  any  material  discrepancy.  Where  these 
comparisons  disclose  repeated  shrinkages  and  the  physical  inven- 
tory was  taken  some  months  prior  to  the  date  of  the  balance 
sheet,  allowance  should  be  made  for  the  estimated  similar  shrink- 
ages in  the  period  since  the  last  physical  inventory  based  on  the 
shortages  in  prior  periods. 

6.  Where  stock  records  are  kept  and  no  physical  inventory 
has  been  taken,  the  former  must  be  very  carefully  investigated  as 
to  the  method  in  use,  the  care  taken  in  carrying  out  the  system, 
and  all  other  features  connected  therewith  which  will  assist  in 
forming  a  conclusion.  Ascertain  when  the  last  physical  inventory 
was  taken  and  compare  same  with  book  records.  If  no  recent 
comparison  is  possible,  select  a  few  book  items  of  importance  and 
personally  compare  with  the  things  themselves.  If  discrepancies 
are  found,  do  not  assume,  without  further  proof,  that  they  are 
clerical  errors  only.  Large  thefts  of  goods  have  been  discovered 
by  tests  of  this  kind. 


l64  AUDITING— GENERAL  PRINCIPLES 

7.  Ascertain  that  purchase  invoices  for  all  stock  included  in 
the  inventory  have  been  entered  in  the  books.  Look  for  post- 
dated invoices  and  give  special  attention  to  goods  in  transit,  the 
aggregate  of  which  shall  be  included  in  the  inventory  and  entered 
as  accounts  payable. 

8.  Ascertain  that  nothing  is  included  in  the  inventory  which 
is  on  consignment  from  others  but  which  is  not  owned.  If  goods 
consigned  to  others  are  included,  see  that  prices  are  placed  thereon 
consistent  with  the  remainder  of  the  inventory,  less  a  proper 
allowance  for  loss,  damage,  or  expenses  of  possible  subsequent 
return.  This  does  not  include  goods  at  branches,  since  the  valu- 
ing of  such  stocks  is  governed  by  the  same  principles  as  apply  to 
the  head  office.  Ascertain  that  nothing  is  included  which  has  been 
sold  and  billed  and  is  simply  awaiting  shipment. 

9.  If  duties,  freight,  insurance,  and  other  direct  charges 
have  been  added,  test  same  to  ascertain  that  no  error  has  been 
made.  Duties  and  freight  are  legitimate  additions  to  the  cost 
price  of  goods,  but  no  other  items  should  be  added  except  under 
unusual  circumstances. 

10.  Cash  discoimts  (that  is,  those  for  bona  fide  prepayment 
and  of  2  per  cent  ^'flat"  or  imder)  need  not  be  deducted  from 
inventory  prices  when  the  concern  consistently  treats  such  dis- 
counts as  a  separate  item  of  income. ""  Discounts  of  more  than 
2  per  cent  are  not  strictly  cash  discounts  and  should  be  deducted 
from  purchases  and  from  inventory  valuations. 

1 1 .  Sometimes  cash  discounts  are  deducted  from  the  purchase 
figures  before  invoices  are  entered  in  the  books,  and  transporta- 
tion charges  are  added.  In  such  cases  care  should  be  taken  to  see 
that  the  inventories  are  figured  on  the  same  basis. 

12.  Select  a  fair  number  of  items  and  compare  the  inventory 
prices  with  the  most  recent  purchase  invoices  for  the  same  kind 
of  goods.  If  the  prices  vary,  ascertain  the  average  cost  of  recent 
purchases. 


=»  See  page  231  for  comment  on  this  rule. 


INVENTORIES— RULES  FOR  VALUATION  1 65 

13.  Make  an  independent  inspection  of  the  inventory  sheets 
to  determine  whether  or  not  the  quantities  are  reasonable,  and 
whether  they  accord  in  particular  instances  with  the  average 
consumption  and  average  purchases  over  a  fixed  period.  If  there 
are  overstocks  the  quotations  for  similar  goods  are  not  conclusive, 
because  it  is  obvious  that  similar  goods  in  quantity  are  not 
wanted,  and  if  not  wanted  there  may  be  no  fair  bid  price  under 
such  conditions.  Exceptionally  large  quantities  of  particular 
items  always  deserve  special  inquiry;  some  general  familiarity 
with  the  normal  stock  which  any  well-conducted  concern,  in  the 
same  line  of  business  should  carry  is  very  desirable. 

In  the  Kingston  Cotton  Mill  Company,  ^  an  English  case,  the 
auditor  failed  to  discover  inflation,  of  some  years'  standing,  of 
both  quantities  and  values  in  the  inventories  of  cotton  and  yarn 
on  hand.  It  appears  to  have  been  admitted  that  a  comparison 
of  the  quantities  of  cotton  purchased  and  of  yarn  sold  with  the 
quantities  in  the  inventories  certified  to  the  auditors  by  the 
managing  director  would  have  disclosed  .the  fact  that  the  quanti- 
ties as  stated  in  the  inventories  could  not  be  correct;  yet,  despite 
this,  the  court  held  that  the  auditors  were  not  guilty  of  negligence. 
The  inventories  were  entered  in  the  balance  sheets  ''as  per 
manager's  certificate,"  and  the  court  appears  to  have  taken  the 
view  that  there  was  no  obligation  on  the  part  of  the  auditors  to 
go  back  of  the  manager's  statement.  Most  prominent  American 
accountants  would  now,  however,  probably  agree  that  such  a 
failure  to  discover  the  true  state  of  affairs  when  the  means  for 
doing  so  were  available  is  inexcusable. 

Remember  that,  in  many  classes  of  goods  of  which  full  stocks 
must  be  kept,  the  sale  of  a  few  articles  at  a  large  gross  profit  is 
sometimes  depended  upon  to  offset  the  probable  loss  on  the  goods 
unsold  in  the  same  class.  The  residual  stock  of  such  classes  may 
have  little  or  no  value. 

Unless  abnormal  conditions  make  the  test  worthless,  attempt 


3  2  Ch.  Div.  279  (Court  of  Appeal,  May  19,  1896). 


1 66  AUDITING— GENERAL  PRINCIPLES 

to  check  the  aggregate  of  the  inventory  by  the  "gross  profit 
test"  and  compare  the  percentage  of  gross  profit  with  that  of 
previous  years.'*  In  a  business  in  which  the  average  gross  profit 
remains  fairly  constant,  this  test  is  trustworthy,  because,  if  the 
rate  of  gross  profit  is  apparently  not  maintained  and  the  dis- 
crepancy cannot  be  satisfactorily  accounted  for  by  a  rise  or  fall  in 
the  cost  of  production  or  of  the  selling  price,  the  cause  of  difference 
is  usually  due  to  errors  in  stock-taking  or  to  the  improper  inflation 
of  values. 

14.  Compare  the  inventory  sheets  in  a  general  way  with  those 
of  the  previous  period,  for  the  purpose  of  noting  any  variation 
in  the  prices  at  which  similar  classes  of  stock  are  taken.  Classify 
the  inventories  of  both  periods  by  commodities  of  the  same  class 
and  also  by  locality. 

15.  After  this  is  completed  and  other  parts  of  the  examina- 
tion about  concluded,  apply  the  knowledge  so  acquired  to  answer- 
ing the  following  questions : 

(a)  Is  any    of    the    stock    damaged,   or    depreciated    in 

quality? 

(b)  Have  the  styles  or  shapes  changed? 

(c)  Is  any  of  the  stock  obsolete,  out  of  date,  of  a  size  or 

quality  no  longer  used? 

(d)  Have  purchases  been  made  in  gross  or  dozen  lots  to  se- 

cure a  low  price,  leaving  many  odds  and  ends  of 
broken  lots? 

4  In  the  Journal  of  Accountancy  for  March,  1921,  page  225,  the  gross  profit 
test  is  explained  as  follows: 

"Stock  on  hand  may  be  estimated  at  dates  between  the  taking  of  physical 
inventories  by  applying  the  gross  profit  method.  The  rate  of  gross  profit  on 
sales  since  the  last  inventory  may  be  estimated  on  the  basis  of  the  rate  of  gross 
profit  earned  on  sales  in  prior  periods.  Any  changes  during  the  period  in  the 
cost  or  selling  price  of  merchandise  would  have  to  be  taken  into  consideration 
in  estimating  any  probable  variation  between  the  rate  earned  in  prior  periods 
and  the  rate  earned  in  the  current  period.  The  sales  since  the  date  of  the  last 
inventory  would  be  multiplied  by  this  estimated  rate  of  gross  profit  to  deter- 
mine the  estimated  gross  profit  on  the  goods  sold.  Then  the  sales  minus  this 
estimated  gross  profit  would  be  the  estimated  cost  of  goods  sold  since  the  last 
inventory.  The  opening  inventory  plus  the  purchases,  freight,  and  other  addi- 
tions to  the  cost  of  goods,  minus  the  estimated  cost  of  goods  sold,  would  give 
the  estimated  inventory. " 


INVENTORIES— RULES  FOR  VALUATION  1 67 

The  physical  condition  and  salability  of  the  stock  must  be 
considered.  If  it  has  deteriorated  or  if  part  of  it  is  out  of  date,  or 
otherwise  unsalable,  it  loses  its  most  important  aspect — avail- 
ability. This  is  a  most  difficult  fact  for  the  auditor  to  determine. 
He  must  depend  upon  his  intuition  and  upon  inquiries  to  deter- 
mine whether  or  not  the  stock  is  in  good  condition  and  merchant- 
able, supplementing  this,  of  course,  by  certificates  from  those  in 
charge  of  the  departments  concerned  covering  this  point  fully. 
When  any  part  of  an  inventory  would  not  be  replaced  if  it  did  not 
exist,  a  prima  facie  case  exists  for  marking  down  the  value.  In 
many  cases  the  actual  market  value  of  overstocks  or  old  stocks 
is  far  below  the  nominal  quotation  for  similar  goods.  The  ques- 
tion to  be  answered  is :  What  is  the  highest  price  I  would  pay  for 
the  goods  in  question?  The  possibility  of  resale  is  an  important 
factor,  but,  if  there  were  a  good  demand  for  the  entire  stock  as  it 
stands,  the  question  of  its  deterioration  would  not  be  under  dis- 
cussion. 

16.  Scrutinize  sales  since  the  inventory  date.  Compare  some 
of  the  items  to  determine  whether  there  is  ample  margin  between 
the  two  prices  to  cover  all  expenses  of  sale  and  handling,  plus  a 
profit.  Otherwise  it  may  be  inferred  that  the  inventory  was 
padded,  and  that  just  cause  exists  for  a  more  comprehensive 
examination. 

17.  In  case  of  goods  which  are  protected  by  firm  sales  orders, 
some  auditors  consider  it  proper  to  value  them  at  cost,  or  as  near 
cost  as  is  justified  by  the  prices  at  which  the  orders  were  taken, 
even  though  such  valuation  is  higher  than  present  market.  It 
should  be  borne  in  mind,  however,  that  sales  orders  are  a  very 
uncertain  quantity  in  a  declining  market,  and  the  auditor  should 
consider  the  standing  of  the  customers,  the  form  of  order  (whether 
subject  to  cancellation  for  any  cause),  and  the  custom  of  the 
trade,  in  determining  how  far  they  are  to  be  treated  as  a  justi- 
fication for  inventorying  high  cost  goods  at  more  than  current 
market  values. 

The  relation  to  one  another  of  the  outstanding  sales  contracts 


1 68  AUDITING— GENERAL  PRINCIPLES 

and  raw  material  purchase  contracts  should  be  carefully  inquired 
into.  In  some  lines  especially,  it  is  possible  that  low  cost  material 
originally  purchased  to  cover  long-term  sales  contracts  (taken  at 
corresponding  prices)  may  in  effect  have  been  used  to  fill  high- 
priced  sales  contracts  taken  for  immediate  delivery.  The  result  is 
that  when  the  higher-priced  raw  materials  (purchased  to  cover 
the  high-priced  sales  contracts)  are  received,  they  will  be  used  to 
fill  low-priced  sales  contracts,  possibly  at  a  loss.  Businesses  in 
which  this  is  a  likely  contingency  should  have  their  accounting 
system  or  their  inventory  methods  so  arranged  that  they  will  take 
cognizance  of,  and  provide  automatically  for,  this  contingency. 

While  not  strictly  connected  with  the  inventory  verification 
itself,  mention  may  not  be  amiss  of  the  necessity  for  ascertaining 
whether  all  materials  or  merchandise  required  to  fill  outstanding 
sales  contracts  have  been  either  purchased  or  can  be  secured  at 
prices  which  will  yield  the  usual  margin  of  profit. 

1 8.  When  the  audit  is  being  made,  during  the  taking  of  the 
inventory  or  immediately  thereafter,  select  some  items  from  the 
inventory  sheets  and  verify  by  inspection  of  the  goods  on  hand. 
It  is  very  important  in  making  this  test  that  the  auditor  should 
work  from  the  sjheets  to  the  stock,  because  it  is  obvious  that  if 
the  inventory  is  overstated  all  the  stock  actually  on  hand  will 
appear  on  the  inventory  sheets,  but  on  the  other  hand  some  items 
would  be  on  the  sheets  for  which  there  were  no  goods  actually  on 
hand. 

19.  Verify  stock  held  in  public  warehouses,  mills,  bleacheries, 
etc.,  by  correspondence.  In  some  cases  an  examination  of  a 
negotiable  receipt  is  considered  sufficient,  but  even  then  it  is 
better  to  make  the  usual  verification  by  letter. 

These  suggestions  may  seem  unduly  extended  and  some  of 
them  not  applicable  to  a  small  business,  or  to  the  case  of  a  quick 
examination  made  to  ascertain  the  condition  of  a  business. 
Close  study  and  slight  modification  to  meet  particular  circum- 
stances will,  however,  prove  their  practicability.    For  discussions 


INVENTORIES— RULES  FOR  VALUATION  1 69 

of  the  best  accounting  methods  of  valuing  and  verifying  inven- 
tories in  particular  trades  and  businesses,  see  Volume  II  under 
appropriate  headings. 

Goods  in  Process 

If  an  adequate  cost  system  is  in  use,  and  is  accurately  kept, 
it  will  be  found  that  monthly,  or  more  frequent,  book  inventories 
can  be  consulted.  Comparisons  should  be  made  of  some  of  the 
items  with  actual  physical  inventories,  and,  if  any  material 
discrepancies  exist,  they  should  be  investigated. 

The  factors  which  enter  into  the  cost  (not  the  value)  of  goods 
in  process  of  manufacture  are:  materials,  labor,  and  factory  over- 
head expenses.    It  is  not  good  accounting  practice  to  increase  the 
book  cost  by  the  addition  of  any  other  elements. 

If  a  good  cost  system  is  not  in  force,  it  is  almost  impossible 
for  an  auditor  to  verify  the  goods  in  process  section  of  the  inven- 
tory satisfactorily.  Where  applicable,  the  general  rules  cited 
above  for  inventories  should  be  followed,  but  most  of  the  items 
will  have  lost  their  identity.  The  difficulty  of  the  task  must  not 
excuse  the  auditor  from  further  inquiry.  He  will  find  in  nearly 
every  case  some  information  bearing  on  the  most  important  thing 
he  wishes  to  know,  viz. :  Is  the  inventory  fairly  priced,  or  is  it 
overstated? 

The  financial  standing  and  profits  of  the  undertaking  must 
also  be  taken  into  consideration.  The  concern  which  realizes 
good  profits  is  not  so  apt  to  overstate  its  inventories  as  the  one 
which  is  hard  pressed  for  capital  or  which  is  unprofitable.  In  the 
latter  cases  nearly  everyone  connected  with  them  may  be  de- 
pended on  to  bolster  up  a  weak  statement  as  much  as  possible. 
No  item  in  the  inventory  is  easier  to  juggle  with  than  that  of 
partly  manufactured  merchandise.  The  most  practical  test  is  an 
examination  of  such  cost  records  as  may  exist.  However  crude 
the  accounting  system,  no  concern  of  any  size  is  without  some 
sort  of  cost  records.  It  may  be  difiicult  to  get  access  to  them, 
since  many  so-called  practical  superintendents  are  strangely  non- 


I70  AUDITING— GENERAL  PRINCIPLES 

communicative  as  to  how  they  arrive  at  their  costs.  They  sup- 
port, with  much  vigor,  the  contention  that  modern  cost  systems 
are  compHcated  and  no  good,  and  that  they  can  calculate  their 
costs  exactly  without  so  much  detail;  but  they  rarely  consent, 
voluntarily,  to  open  up  their  records.  Yet  there  must  be  some- 
body who  makes  up  the  costs,  and  the  production  of  these  records 
should  be  insisted  upon.  The  cost  sheets  should  show  the  suc- 
cessive steps  of  each  article  manufactured,  and  some  of  the  stages 
may  be  identified  with  the  inventory  items. 

The  auditor  should  probably  leave  this  part  of  the  audit  until 
the  end.  If  the  valuations  of  raw  materials,  manufactured  goods, 
plant  and  machinery,  accounts  receivable,  etc.,  are  conservative, 
he  is  not  called  on  to  make  an  exhaustive  inquiry  into  goods  in 
process.  On  the  other  hand,  if  other  items  are  overvalued,  the 
chances  are  that  this  item  will  be  overvalued  even  more,  and  he 
should  act  accordingly  in  making  his  recommendations  as  to 
reductions  in  inventory  valuations.  When  market  conditions 
have  changed  since  the  cost  bases  of  the  goods  in  process  were 
determined,  it  is  necessary  to  adjust  the  total  values  to  conform 
to  the  changes  made  in  the  stock  of  raw  materials. 

It  seems  hardly  necessary  to  add,  that  in  passing  upon  the 
valuations  of  all  stocks  of  partly  finished  goods  it  should  be  defi- 
nitely ascertained  that  all  of  the  stock  will  be  completed  within 
a  reasonable  time. 

Finished  Goods 

If  a  good  system  of  cost  accounts  is  not  in  force,  difficulty  will  be 
experienced  in  passing  upon  the  prices  placed  upon  stock-in-trade 
which  has  been  wholly  or  partly  manufactured  by  the  client.  If 
the  cost  system  is  accurate  and  trustworthy,  care  must  be  taken  to 
ascertain  that  the  results  secured  with  it  are  used  as  the  basis  for 
the  inventory.  A  practice  which  deserves  condemnation  is  that 
of  pricing  finished  goods  at  sales  prices  irrespective  of  firm  orders, 
less  an  estimated  cost  of  delivery  and  similar  charges.  ^    This,  of 

s  For  discussion  of  exceptions  to  this  general  rule,  see  page  147. 


INVENTORIES— RULES  FOR  VALUATION  I7I 

course,  anticipates  the  entire  profit  on  such  sales,  but  it  is 
not  considered  to  be  conservative  to  take  credit  for  profits 
which  are  not  fully  earned,  until  delivery  has  been  made  and  a 
cause  of  action  established  against  a  solvent  debtor.  Until  de- 
Hvery  has  been  made  and  the  goods  accepted,  the  sales  contract 
is  not  complete.  It  is  not  uncommon  for  orders  to  be  canceled  or 
goods  refused  for  so  many  reasons  that  they  cannot  be  enumer- 
ated here,  therefore  conservative  manufacturers  rarely  consider 
that  any  profit  is  earned  on  undelivered  goods.  When  for  bal- 
ance sheet  purposes  it  is  deemed  to  be  advisable  to  show  the  value 
rather  than  the  cost  of  part  of  the  inventory,  the  unreaHzed 
profit  must  not  be  merged  with  the  current  income  but  must  be 
separately  stated. 

Some  cost  systems  include  ordinary  overhead  charges,  and 
others  go  so  far  as  to  include  rent  and  interest.  In  a  balance  sheet 
which  is  to  be  used  as  a  basis  for  credit,  the  item  of  interest  should 
not  be  considered  as  a  part  of  the  cost  of  the  goods  imsold,  and 
other  items  nearly  as  questionable,  such  as  rent,  administrative 
salaries,  etc.,  should  be  excluded,  unless  the  auditor  is  fully  con- 
vinced that  their  inclusion  is  in  order.  In  other  words,  do  not 
certify  to  an  "inventory  at  cost"  item  in  the  balance  sheet  unless 
assured  that  "cost"  in  that  particular  case  carries  with  it  its 
own  explanation,  and  that  subsequent  criticism  cannot  arise. 
"Cost"  may  include  all  expenses  incurred  in  manufacturing, 
except  selling  and  managerial  expenses,  but  no  profit  may  be 
included.  Selling  and  administrative  expenses  continue  after  the 
inventory  date.  Those  incurred  prior  thereto  should  be  charged 
off. 

It  is  obvious  that  the  "inventory  at  cost"  item  should  be  so 
certified  only  if  the  cost  price  is  below  the  net  selling  price,  allow- 
ing for  all  expenses  of  sale  and  carrying,  and  if  similar  goods  can- 
not be  duplicated  in  the  market  at  a  smaller  cost.  This  may  be  a 
difficult  point  to  pass  upon,  but  it  must  nevertheless  be  dealt  with. 
One  test  is  found  in  the  general  results  of  the  business.  If  con- 
ducted at  a  loss,  it  may  easily  be  true  that  costs  are  excessive,  so 


172  AUDITING— GENERAL  PRINCIPLES 

that  to  use  such  figures  would  be  to  overvalue  the  assets  to  that 
extent.  If  a  factory  is  running  on  part  time  only,  or  if  it  is  a  new 
enterprise,  the  actual  cost  of  production  may  be  in  excess  of  the 
market  value  of  similar  goods.  In  such  cases  the  stock  should  be 
marked  down  to  the  market  price. 

In  other  respects  the  procedure  in  verifying  the  inventory  of 
finished  goods  is  the  same  as  that  suggested  for  ''raw  materials."^ 

If  by-products  are  manufactured  from  the  scrap  or  waste 
material,  and  if  the  by-product  cost  includes  the  cost  of  the  raw 
material  which  would  otherwise  be  scrapped,  the  auditor  should 
satisfy  himself  that  the  cost  of  the  main  product  does  not  also 
include  the  value  of  the  scrapped  material. 

Supplies,  Stores,  etc. 

In  addition  to  the  regular  stock-in-trade,  other  supplies  are 
usually  on  hand  and  should,  of  course,  appear  in  the  inventory, 
unless  the  total  value  is  very  small. 

These  items  should  be  separated  from  the  merchandise  stock. 
Such  items  as  fuel,  office  and  factory  supplies,  and  similar  mate- 
rials and  stores  are  in  the  same  class  as  raw  materials.  Repair 
parts  and  construction  items  are  not  current  assets.  Ordinary 
repair  parts  and  similar  items  which  are  to  be  used  and  charged  to 
maintenance,  say,  within  a  year,  are  current  assets  and  may  be 
included. 

The  general  rules  of  inventory  valuation  apply.  Care  must 
be  taken  that  nothing  is  included  except  usable  items.  The  audi- 
tor should  demand  the  original  stock  sheets  and  test  their  accu- 
racy sufficiently  to  satisfy  himself  that  the  items  are  genuine  ones, 
and  that  quantities  are  not  overstated. 

It  is  sometimes  found  that  partly  used  articles  are  included 
under  this  caption;  except  under  special  circumstances,  it  is  not 
proper  to  include  anything  except  new  and  usable  materials, 
which  would  have  to  be  duplicated  at  the  same  or  a  greater  cost  if 
they  were  not  on  hand. 

^  See  page  162. 


CHAPTER  X 

BALANCE  SHEET  AUDIT— FIXED  ASSETS 

In  a  balance  sheet  audit  the  duty  of  the  auditor  regarding 
current  assets  differs  from  his  duty  regarding  fixed  assets;  as  to 
the  former  he  must,  upon  his  own  responsibihty ,  verify  both  exist- 
ence and  value,  or  else  specify  in  his  certificate  the  extent  to  which 
he  has  relied  on  the  statements  of  others;  as  to  the  latter,  it  is 
good  practice  to  depend  largely  on  the  information  to  be  secured 
from  others. 

Nature  of  Fixed  Assets 

As  distinguished  from  current  assets,  those  more  or  less  perma- 
nent and  with  which  the  business  is  carried  on  are  generally 
known  as  fixed  assets.  Instead  of  being  offered  for  sale,  they  are 
maintained,  or  renewed,  and  their  use  provides  the  means  of 
carrying  on  the  business.  The  term  "fixed  assets"  includes  land, 
buildings,  machinery  and  equipment,  tools,  patterns  and  draw- 
ings, furniture  and  fixtures,  at  cost  less  normal  depreciation. 
When  appraisals  are  made  in  which  appreciation  is  included, 
there  is  no  objection  to  setting  up  appraised  values  in  balance 
sheets,  provided  the  valuation  is  qualified  by  an  explanation  and 
provided  the  excess  of  the  appraisal  above  book  value  is  credited 
to  special  or  capital  surplus  and  is  not  merged  in  earned  surplus. 
This  practice  is  not  permissible,  however,  under  an  agreement 
with  creditors  in  which  fixed  assets  are  mentioned  but  are  not 
specifically  defined.  It  would  be  deemed  to  be  a  breach  of 
such  an  agreement  if  book  values  as  stated  at  the  date  of  the 
agreement  are  increased,  except  for  actual  additions  to  property. 
The  term  "fixed  assets"  also  includes  notes,  securities  such  as 
bonds  and  stocks,  and  similar  items  not  properly  included  as 

173 


174  AUDITING— GENERAL  PRINCIPLES 

current  assets.  There  also  should  be  included  among  fixed  assets 
good  deferred  assets,  such  as  cash  deposits  not  available 
for  current  use,  development  work  in  mines,  cost  of  contracts, 
and  other  prepaid  items  which  are  only  in  part  properly 
chargeable  to  current  operating  costs  or  expenses  and  which 
therefore  are  to  be  amortized  over  more  than  one  year's  opera- 
tions, and  actual  cost  of  leaseholds  and  improvements  amortized 
over  the  terms  of  the  leases  (including  if  desirable  the  terms  of 
years  for  which  renewable  options  at  stated  rentals  are  held). 

But  items  such  as  organization  expenses,  and  similar  items 
which  are  not  chargeable  to  current  operating  costs  of  any  period 
must  not  be  included  among  fixed  assets. 

The  term  ''fixed  assets,"  as  generally  understood,  does  not 
include  patents,  trade-marks,  good-will,  and  similar  intangible 
assets,  because  assets  of  this  nature  rarely  represent  the  expendi- 
ture of  cash.  It  would  seem  that  whenever  patents  and  similar 
assets  are  purchased  for  cash,  the  assets  at  cost  price  should  there- 
after be  included  among  fixed  assets. 

The  term  ''fixed  assets"  is  not  synon)nnous  with  "tangible 
assets,"  since  the  latter  includes  "current  assets."  The  term  "net 
fixed  assets"  is  not  used  because  of  the  difficulty  of  deciding  which 
liabilities  to  deduct. 

Tangible  Assets. — The  term  "tangible  assets"  is  a  technical 
rather  than  a  legal  term.  Items  are  included — such  as  accounts 
receivable — which  in  a  strict  legal  sense  are  "intangible." 

The  term  "tangible  assets"  includes  current  assets  and  fixed 
assets  as  defined,  but  does  not  include  intangible  assets,  such  as 
good-will,  patents,  patent  rights,  trade-marks,  brands,  and  trade- 
names. When  intangibles  have  been  purchased  for  cash,  there 
seems  to  be  no  good  reason  why  the  assets  so  acquired  should  not 
be  included  among  tangible  assets  when  that  term  is  defined, 
solely  to  protect  bond,  note,  and  preferred  stock  issues;  but  the 
term  is  not  elastic  enough  in  the  usual  agreement  to  cover  the 
items  mentioned. 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  1 75 

When  the  auditor  is  not  Hmited  by  a  trust  agreement,  the 
expenditure  of  cash  for  patents  or  trade-marks  should  be  included 
among  the  fixed  assets,  with  a  proper  explanation. 

The  term  "net  tangible  assets"  means  the  excess  of  tangible 
assets  over  all  liabilities. 

Plant  Accounts  Must  Be  Analyzed 

When  an  audit  covers  several  years,  or  the  entire  life  of  the 
undertaking,  an  analysis  of  the  items  of  fixed  plant  is  made  in  due 
course  and  the  auditor  then  has  before  him  all  the  facts  upon 
which  to  base  an  opinion  as  to  whether  or  not  the  accounts  re- 
present fair  cost  of  the  existing  assets.  In  a  balance  sheet  audit, 
however,  the  period  to  be  covered  usually  rests  with  the  auditor, 
and  a  serious  question  arises  as  to  how  far  the  book  valuations 
may  be  accepted  as  a  basis  for  actual  values,  assuming  that  the 
concern  is  to  be  valued  as  a  going  business,  and  that  cost,  less 
proper  depreciation,  is  the  result  desired. 

The  auditor  may  as  well  accept  the  position  here,  as  with 
inventories,  that  he  is  expected  to  report  the  facts  about  the 
plant  account;  where  he  cannot  secure  reliable  information  with 
respect  to  plant  values  he  should  state  in  his  report  that  real 
estate,  machinery,  and  similar  assets  are  stated  at  book  valua- 
tions. He  should,  however,  attempt  to  ascertain  whether  these 
book  valuations  honestly  reflect  present  conditions.  His  services 
are  of  little  real  value  if  such  items  are  grossly  overvalued  and  if  a 
net  worth  is  shown  which  should  be  corrected  by  an  intelligent 
use  of  evidence  readily  available. 

The  auditor's  duty  is  to  analyze  the  items  of  fixed  assets  as 
shown  by  the  books,  to  enable  him  to  ascertain  the  principles 
upon  which  they  have  been  created.  In  a  few  large  enterprises  an 
item  of  ''plant "  may  appear  which  represents  an  aggregate  valua- 
tion covering  the  purchase  price  of  perhaps  the  entire  fixed  prop- 
erty. It  may  be  largely  overvalued  to  offset  common  capital 
stock  issued  in  payment  therefor.  In  such  cases,  and  in  the  ab- 
sence of  an  appraisal  to  fix  actual  physical  values,  the  problem  is 


176  AUDITING— GENERAL  PRINCIPLES 

difficult  and  requires  more  attention  than  can  be  devoted  to 
it  in  a  general  treatise  of  this  nature.  The  auditor,  of  course,  can- 
not intelligently  criticize  such  a  valuation,  even  if  it  is  absurdly 
excessive,  unless  he  can  secure  an  appraisal,  approximate  or  actual. 
A  statement  that  the  plant  is  obviously  greatly  overvalued  may 
lead  bankers  or  others  interested  to  call  for  an  appraisement. 

Auditors  whose  practice  is  chiefly  with  large  corporations 
meet  with  this  problem  frequently.  Mergers  and  reorganizations 
lead  to  the  creation  of  ''lump"  sums  among  fixed  assets.  Any 
analysis  thereof  is  out  of  the  question.  The  records  are  not,  as  a 
rule,  available,  and  if  they  are  there  are  so  many  changes  in  the 
principal  items  that  the  auditor  is  not  much  better  off  as  a  result. 
The  property  of  large  corporations  is  apt  to  depreciate  or  appre- 
ciate to  a  considerable  extent;  it  rarely  stands  still.  The  Inter- 
state Commerce  Commission  requested  an  analysis  of  the  property 
accounts  of  all  railroad  companies  reporting  to  it,  but  frankly 
gave  up  the  problem  and  finally  settled  on  the  requirement  that 
all  additions  subsequent  to  July  i,  1907,  be  analyzed  in  detail. 

This  course  may  be  followed  to  advantage  in  industrial  cor- 
porations. The  lack  of  past  data  is  no  excuse  for  a  continuance  of 
poor  bookkeeping,  and  the  auditor  who  has  any  influence  in  the 
matter  should  request  that  intelhgent  analyses  of  all  capital 
expenditures  be  preserved. 

In  many  corporations  the  property  accounts  represent  merely 
the  securities  issued,  and  their  actual  value  was  not  of  prime  im- 
portance to  the  auditor  until  the  enactment  of  the  Federal  Rev- 
enue Act  of  191 7.  In  this  act  the  basis  of  the  determination  of 
liability  for  the  excess  profits  tax  rested  upon  so-called  invested 
capital,  which  in  turn  was  defined  to  be  the  cash  cost  or  cash 
value  of  assets  when  acquired.  Appreciation  was  specifically 
disallowed.  ^    It  became  necessary  that  books  of  account  should, 


^  For  interpretation  of  invested  capital  provisions  of  the  Revenue  Acts 
of  1917  and  1918,  see  Excess  Profits  Tax  Procedure,  1921;  also  see  LaBelle 
Iron  Works  v.  U.  S.,  U.  S,  Supreme  Court,  May  16,  1921.  Not  yet  re- 
ported. Quoted  in  full  in  Corporation  Trust  Co.  War  Tax  Service,  192 1,  par. 
899-922. 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  177 

when  feasible,  show  cost  of  plant  assets  less  normal  or  reasonable 
depreciation.  When  the  books  of  account  did  not,  or  do  not, 
show  such  figures,  it  is  permissible  under  the  Treasury  regulations 
to  adjust  the  books. 

Aside  from  pre-existing  book  values  of  the  plant  accounts,  the 
auditor  is  greatly  interested  in  the  operation  and  development  of 
the  enterprises  and  must  assume  the  responsibihty  of  classifying 
subsequent  expenditure  between  capital  and  income.  In  a  great 
many  balance  sheet  audits,  data  can  be  secured  with  little  trouble 
which  show  the  component  elements  of  the  values,  viz.,  the  book 
cost  of  the  various  divisions  of  the  plant  and  equipment  accounts, 
also  whether  the  charges  appear  to  include  only  items  of  additions 
and  betterments,  and  whether  depreciation  has  been  provided  for. 

In  brief,  in  all  balance  sheet  audits  the  auditor  must,  if  pos- 
sible, secure  an  analysis  of  the  existing  book  valuations,  even  if 
it  is  necessary  to  go  back  over  the  transactions  of  many  years. 
The  absence  of  plant  ledgers  containing  explanatory  details  is  an 
omission  which  should  be  commented  upon  unfavorably.  The 
borrowers  whose  books  do  not  lend  themselves  readily  to  an  audit 
by  professional  accountants  are  usually  the  ones  whose  financial 
statements  require  serious  scrutiny  on  the  part  of  prospective 
lenders  and  creditors. 

METHODS  OF  ARRIVING  AT  BALANCE  SHEET 
VALUATIONS 

We  are  dealing  with  enterprises  which  are  continuing  in  busi- 
ness, of  which  a  forced  sale  or  liquidation  is  not  contemplated; 
so  that  in  attempting  to  fix  the  net  value  of  a  concern's  fixed 
assets  we  may  say  that,  as  a  general  rule,  the  correct  basis  is  cost, 
less  an  adequate  allowance  for  depreciation,  due  to  wear  and 
tear  and  obsolescence. 

It  need  not  be  considered  (although  it  is  true)  that  the  dis- 
mantling of  a  plant  or  a  forced  sale  under  unfavorable  circum- 
stances will  seriously  disarrange  the  book  values,  provided  the 

VOL.  I — 12 


178  AUDITING— GENERAL  PRINCIPLES 

latter  are  based  on  the  foregoing  rule.  This  aspect  of  the  case  is 
well  known  to  all  interested  parties  and  no  one,  not  even  a  banker, 
contends  that  the  balance  sheet  of  a  live  enterprise  should  exhibit 
its  assets  at  a  ''scrap"  valuation. 

There  is  no  uniformity  in  terminology  regarding  plant  assets 
in  balance  sheets.  In  a  few  cases  plant  and  good- will  are  not 
separated.  In  the  case  of  the  best  concerns,  plant  accounts  are 
segregated  to  some  extent  and  in  the  balance  sheet  or  in  the 
auditor's  certificate  the  statement  is  made  that  adequate  provi- 
sion has  been  made  for  depreciation.  In  perhaps  the  majority 
of  cases  the  amounts  of  depreciation  reserves  are  shown.  In  those 
balance  sheets  where  there  is  evidenced  the  greatest  desire  to  keep 
stockholders  and  others  informed,  the  additions  and  the  deprecia- 
tion for  the  period  are  shown.  The  practice  is  common  enough 
to  justify  the  statement  that  under  good  accounting  practice 
changes  in  depreciable  assets — additions  and  deductions — are 
shown  in  balance  sheets. 

In  arriving  at  the  book  value  of  plant  and  property  as  a  going 
concern,  it  is  necessary  that  the  proper  distinction  be  drawn 
between : 

1.  Additions  to  be  capitalized. 

2.  Renewals  to  be  debited  to  depreciation  reserves. 

3.  Current  repairs  to  be  absorbed  in  operating  expenses. 

When  dealing  with  the  foregoing  in  theory  and  when  books 
are  properly  kept,  the  distinction  is  so  clear  that  any  discussion 
seems  superfluous.  When  dealing  with  past  transactions,  mostly 
without  details,  the  auditor  sometimes  finds  the  task  to  be 
hopeless.  When  books  are  not  properly  kept  it  is  necessary,  in 
respect  to  (i)  to  secure  a  description  of  what,  if  any,  additions 
have  been  made,  and  then  to  ascertain  to  which  accounts  the  cost 
of  the  additions  has  been  charged.  If  not  capitalized,  the  items 
should  be  transferred  to  asset  accounts.  In  respect  to  (2),  it  is 
also  feasible  to  secure  a  general  description  of  renewals  made  dur- 
ing certain  periods.     If  the  renewals  have  been  capitalized  or 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  1 79 

charged  off,  it  is  necessary  to  adjust  the  accounts.  When  depre- 
ciation reserves  are  not  kept  and  the  cost  of  renewals  averages 
about  the  same  over  a  period  of  years,  the  setting  up  of  deprecia- 
tion reserves  and  the  charging  of  the  cost  of  renewals  against  the 
reserves  does  not  affect  the  net  result.  Nevertheless  the  accounts 
should  be  adjusted  to  give  effect  to  this  procedure  because  tax 
and  other  requirements  demand  that  good  accounting  practice  be 
observed.  Careful  attention  to  (i)  and  (2)  will  prove  to  be  an 
almost  complete  check  on  (3). 

The  elimination  of  additions  and  renewals  from  repairs  and 
maintenance  accounts  affords  an  opportunity  to  measure  the 
adequacy  or  inadequacy  of  the  expenditures  for  current  repairs. 
Reserves  for  depreciation  are  not  intended  to  provide  for  the 
current  up-keep  of  plant  and  equipment.  If  proper  repairs  are 
not  made,  a  going  concern  property  deteriorates  to  an  extent  not 
covered  by  ordinary  depreciation.  It  is  not  usual  to  provide 
reserves  for  deferred  maintenance  except  in  the  case  of  concerns 
such  as  pubhc  utilities  which  are  unable  to  secure  funds  to  care 
properly  for  their  properties.  The  mere  fact  that  it  is  not  usual 
does  not  reheve  an  auditor  from  an  investigation  into  existing 
conditions.  If  the  repairs  and  maintenance  accounts  are  unduly 
low  for  the  period  under  examination,  the  auditor  should  endeavor 
to  ascertain  a  fair  average  allowance  for  such  expense,  and  the 
deficiency  should  be  charged  to  operating  expenses  and  be  offset 
by  the  setting  up  of  a  reserve  account. 

Land  and  Buildings 

Many  auditors  are  too  prone  to  take  it  for  granted  that  real 
estate,  a  record  of  which  appears  in  the  books  of  account  as 
owned,  is  actually  the  property  of  the  business  under  audit,  and 
that  its  title  is  free  and  clear  unless  a  mortgage  appears  on  the 
books.  In  fact,  serious  flaws  have  developed  in  the  title  to  real 
estate  carried  as  an  asset  on  balance  sheets  which  have  been  relied 
upon  as  a  basis  for  credit. 

This  is  not  a  difficult  matter  to  cover;  much  easier,  in  fact, 


l8o  AUDITING— GENERAL  PRINCIPLES 

than  many  of  the  other  items  of  considerably  smaller  amount  on 
the  balance  sheet.  The  most  practicable  method,  and  one  on 
which  an  auditor  can  rely,  is  to  secure  from  the  attorney  or  from 
a  title  company  a  letter  or  certificate,  properly  signed,  stating: 

1.  Whether  the  title  to  the  real  estate  as  it  appears,  or  as  it 

is  described,  on  the  books,  is  in  the  name  of  the  in^ 
dividual,  firm,  or  corporation  whose  name  appears  at 
the  top  of  the  balance  sheet  or  in  the  auditor's  certifi- 
cate. 

2.  That  the  said  real  estate  is  free  from  any  liens  whatever, 

including  the  following: 

(a)  Mortgages 

(b)  Judgments 

(c)  Taxes,  water  rent,  or  other  municipal  liens 

The  foregoing  liens,  if  disclosed,  should  appear  among  the 
liabilities,  but  the  time  to  cover  this  point  in  an  audit  is  when  the 
verification  of  the  asset  side  of  the  balance  sheet  is  being  made. 

It  may  be  urged  that  an  auditor  should  not  depend  upon 
the  certificate  of  an  attorney  when  there  is  no  special  difficulty 
in  having  a  search  of  the  pubhc  records  made  by  his  own  staff, 
or  by  someone  not  connected  with  the  enterprise;  but  in  prac- 
tically all  cases  the  result  would  not  be  any  more  satisfactory, 
and  in  most  cases  difficulties  present  themselves  which  make  it 
inadvisable  for  the  auditor  to  attempt  to  do  the  work  of  a  la^xyer. 

An  important  distinction  which  must  not  be  lost  sight  of  is  the 
classification  of  the  real  estate.  A  balance  sheet  should  always 
show : 

1.  Real  estate  used  in  the  business 

2.  Other  real  estate  (if  any) 

This  segregation  appHes  to  all  concerns  except  those  in  which 
real  estate  is  dealt  in  as  a  commodity.  Taken  in  connection  with 
the  income  account,  it  shows  at  a  glance  whether  the  outside 
real  estate  is  producing  enough  revenue  to  warrant  holding  it; 
and  taken  into  consideration  with  respect  to  the  indebtedness,  it 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  l8l 

affords  an  opportunity  to  decide  whether  it  is  wise  to  hold  it  in- 
definitely. 

I.  Land. — Land  should  appear  in  the  balance  sheet  at  cost. 
It  should  not  be  written  up  (except  under  special  circumstances 
discussed  elsewhere),  although  it  may  be  clearly  established 
that  its  value  has  increased.  As  a  matter  of  fact,  an  increment  in 
the  stated  value  of  land  upon  which  factory  buildings  are  erected, 
usually  means  higher  taxes,  with  no  increase  in  earning  power,  so 
that  an  increased  valuation  is  a  detriment  so  far  as  current  opera- 
tions are  concerned.  The  business  .does  not  receive  any  benefit 
therefrom  except  in  case  of  sale  or  liquidation,  and  an  adjust- 
ment of  the  book  value  need  not  be  made  until  these  actually 
occur. 

Similarly,  if  the  land  has  apparently  depreciated  in  value, 
custom  justifies  the  carrying  of  this  item  at  cost  until  realization, 
at  which  time  only  can  the  actual  value  be  determined. 

A  distinction  must  be  made  between  improved  and  unim- 
proved property.  In  case  of  the  latter,  taxes  and  other  carrying 
charges  are  sometimes  added  to  the  cost.  The  auditor  should 
make  a  careful  analysis  of  the  items  for  use  in  his  report.  The 
facts  speak  for  themselves  so  strongly  that  the  auditor  need  do  no 
more  than  refer  to  the  items.  All  carrying  charges,  including 
interest,  should  be  treated  as  revenue  expenditures  unless  it  is 
obvious  that  there  is  a  continuous  increase  in  the  actual  value  of 
the  property.  When  this  is  affirmatively  shown,  the  carrying 
charges  may  be  capitalized. 

Where  the  auditor  finds  that  an  adjustment  increasing  the 
book  value  of  land  has  been  made,  the  fact  should  be  noted  on  the 
balance  sheet.    Otherwise  a  situation  like  the  following  may  arise : 

A  corporation  had  accumulated  .an  operating  loss  of  about 
$200,000.  Its  land  was  within  the  limits  of  a  large  city  and  had 
obviously  increased  greatly  in  value,  but  no  adjustment  had  been 
made  for  this  in  the  books.  The  company  was  at  times  a  bor- 
rower up  to  about  a  million  dollars,  and  the  banks  required  period- 


1 82  AUDITING— GENERAL  PRINCIPLES 

ical  financial  statements.  The  banks  did  not,  however,  require, 
and  the  corporation  did  not  furnish,  the  certified  statements 
furnished  by  the  auditors  (which  exhibited  the  land  at  cost  and 
the  deficit  mentioned  above),  but  the  corporation  did  furnish  a 
balance  sheet  in  which  the  land  value  was  marked  up  several 
hundred  thousand  dollars — enough  to  wipe  out  the  deficit  and  to 
produce  a  surplus.  As  the  land  valuations  were  not  excessive,  the 
banks  were  not  put  upon  notice  that  the  company  was  losing 
money  and  that  the  books  showed  a  deficit. 

Property  situated  in  or  near  a  city  may  appreciate  greatly  in 
value  as  time  goes  on,  due  to  transfers  or  appraisements  of  land 
similarly  located.  It  must  be  remembered,  however,  that  it  is  a 
fallacy  to  assume  that  the  value  of  land  available  for  any  kind  of 
improvement  can  be  directly  compared  with  the  value  of  land 
upon  which  a  manufacturing  plant  has  been  erected.  The  value 
of  the  plant  cannot  be  separated  from  the  value  of  the  land  itself, 
because,  based  upon  the  assumption  that  the  land  could  be  sold 
for  general  purposes,  in  99  cases  out  of  100  the  buildings  (being 
adapted  for  one  purpose  only)  would  have  to  be  demolished  and 
the  capital  loss  thus  sustained  would  more  than  offset  the  appre- 
ciation in  the  value  of  the  land. 

Therefore  an  apparent  rise  in  the  value  of  the  land  is  not  the 
equivalent  of  an  increase  in  assets  unless  the  proportion  the  im- 
provements bear  to  the  entire  investment  is  a  small  one.  The 
auditor  can  readily  test  the  propriety  of  such  a  statement  of 
increased  land  value  by  asking  the  question :  Is  the  land  avail- 
able for  sale  aside  from  the  improvements? 

Bankers  are  strangely  neghgent  in  accepting  unverified  state- 
ments, when  without  cost  to  them,  they  could  just  as  well  have 
the  facts.  No  borrower  can  afford  to  refuse  to  furnish  a  certified 
statement  when  called  upon  to  do  so  by  a  lender. 

2.  Buildings. — The  valuation  of  buildings  brings  up  the 
question  of  depreciation,  which  is  discussed  fully  in  Chapter 
XXVIII.    Following  the  suggestions  there  made,  buildings  should 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  1 83 

appear  on  the  balance  sheet  at  cost,  and  a  reserve  should  be 
created  sufficient  to  cover  the  wear  and  tear,  obsolescence,  and 
inadequacy  thereof,  accrued  to  the  date  of  the  balance  sheet. 

As  an  aid  to  forming  an  opinion  upon  the  value  of  buildings, 
the  auditor  should  personally  inspect  the  plant  and  note  whether 
it  appears  to  be  in  good  condition. 

Where  land  has  been  acquired  through  gift  from  a  municipal- 
ity or  public  body,  title  to  be  transferred  when  certain  conditions 
are  fulfilled,  the  land  should  be  appraised  at  the  time  when  it  is 
taken  over,  but  the  value  should  not  be  included  as  an  asset 
until  all  conditions  are  fulfilled  and  then  at  the  appraisal  value. 

Leaseholds 

Not  many  manufacturing  plants  in  the  United  States  are  built 
on  leased  premises,  but  inquiry  as  to  this  should  be  made,  never- 
theless, in  every  audit  where  real  estate  appears  as  an  asset.  In 
a  surprisingly  large  number  of  cases  department  stores,  hotels, 
theaters,  office  and  "loft"  skyscrapers,  and  other  business  build- 
ings are  erected  on  land  which  is  leased  for  a  definite  term  of 
years. 

Prior  to  the  enactment  of  the  federal  excess  profits  tax  law  in 
191 7,  it  was  not  customary  for  the  owners  of  such  buildings  to 
provide  a  sinking  fund  to  take  care  of  the  diminishing  value  of 
their  property,  or  even  to  charge  depreciation  as  one  of  their 
expenses.  There  were  two  reasons  for  this:  first,  the  term  is  usu- 
ally a  long  one,  running  from  21  to  99  years.  In  this  age  of 
startling  changes  such  long  terms  or  one  of  63  or  84  years — the 
latter  being  the  most  popular  in  New  York  City — is  equivalent, 
in  the  minds  of  real  estate  operators,  to  a  freehold.  No  provision 
for  the  far-distant  future  seemed  necessary.  Secondly,  in  the 
great  majority  of  cases  land  has  appreciated  in  value  faster  than 
the  buildings  thereon  have  depreciated.  For  instance,  a  building 
on  upper  Fifth  Avenue,  New  York,  built  20  years  ago  on  leased 
ground,  with,  say,  43  years  to  run  before  the  lease  expires,  could 
be  demolished  and  the  vacant  land  sublet  for  a  great  deal  more 


1 84  AUDITING— GENERAL  PRINCIPLES 

than  the  building  is  worth,  in  addition  to  the  rental  under  the 
original  lease.  With  similar  experiences  in  other  cities  formerly 
it  was  difficult  to  persuade  the  builder  that  a  sinking  fund  should 
be  created,  but  after  profits  taxes  became  a  factor  he  willingly 
admitted  and  claimed  that  buildings  depreciate  in  value. 

It  now  needs  no  argument  to  sustain  the  contention  that  the 
depreciation  in  value  of  a  building,  computed  on  its  life  and  on  the 
expiration  of  the  lease,  is  an  annual  charge  against  the  revenue 
which  the  building  produces;  that  unless  and  until  the  leasehold 
is  sold  or  parted  with,  the  only  fads  at  hand  are  that  the  build- 
ing is  diminishing  in  value,  slowly  but  surely,  from  the  two 
causes  stated. 

An  auditor  should  not  set  off  appreciation  against  depreciation 
without  so  stating  the  fact  in  his  certificate  or  showing  it  on  the 
balance  sheet;  otherwise  he  is  guilty  of  conniving  at  a  practice 
shimned  by  all  conservative  men,  viz.,  taking  credit  in  a  current 
period  for  a  prospective  profit  without  showing  the  facts  in  all 
pubhshed  statements.  Nevertheless,  he  must  not  ignore  the 
question  of  a  rise  in  value,  since  it  may  have  an  important  bear- 
ing on  the  borrowing  capacity  of  the  concern.  Therefore,  when- 
ever an  auditor  meets  with  a  claim  that  the  unexpired  portion  of 
a  leasehold  is  of  great  value,  he  should  secure  an  appraisal  thereof 
by  a  reliable  and  disinterested  real  estate  agent,  and  the  value 
may  be  reflected  in  the  balance  sheet.  The  offsetting  credit  must 
be  special  or  capital  surplus — not  earned  surplus. 

If  a  lease  has  been  purchased,  and  if  the  purchase  price  appears 
on  the  books  as  an  asset,  the  expired  portion  should  be  written  off 
periodically.  If  an  appraisal  establishes  the  fact  that  the  price 
paid  was  too  high,  it  is  wise  and  conservative  to  increase  the 
instalments  to  such  an  extent  that  the  cost  will  be  written  off 
before  the  expiration  of  the  lease.  But  if  this  is  not  satisfactory 
to  the  lessee,  the  auditor  is  not  justified  in  insisting  upon  it,  any 
more  than  he  is  in  requiring  a  tenant,  who  under  a  long  lease  is 
paying  more  rent  than  similar  space  could  be  secured  for  later, 
to  set  up  a  reserve  for  excessive  rent. 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  1 85 

Machinery  and  Equipment 

As  with  buildings,  machinery  should  be  valued  at  cost  and 
an  adequate  reserve  should  be  provided  to  cover  depreciation. 
In  determining  the  sufficiency  of  the  machinery  reserve,  consider- 
ation should  be  given  to  the  question  of  obsolescence.  No  general 
rule  can  be  found  which  governs  the  rates  of  depreciation  appli- 
cable to  a  particular  plant.  Much  depends  upon  the  way  the 
machinery  is  used  and  cared  for.  The  hfe  of  a  lathe  in  one  plant 
may  be  twenty  years;  in  another  the  same  lathe  will  be  out  of 
commission  in  ten  years. 

The  auditor  must  apply  the  general  principles  of  depreciation 
to  the  item  of  machinery  and  then  bring  to  bear  the  special 
knowledge  he  has  gained  of  the  plant  under  review  before  express- 
ing his  opinion  as  to  the  accuracy,  or  otherwise,  of  the  book  values. 

The  auditor  should  not  fail  to  inquire  whether  a  detailed 
record  is  available  showing  the  particulars  of  the  cost,  etc.,  of 
the  machinery.  In  many  factories  such  a  record  is  kept  for  insur- 
ance purposes  or  as  a  check  on  depreciation  charges.  This  record 
is  found  usually  on  cards  or  in  a  loose-leaf  book,  and,  as  it  is  not 
considered  one  of  the  regular  books  of  accoimt,  it  will  not  be  sub- 
mitted to  the  auditor  unless  he  asks  for  it.  If  accurate,  it  is  an 
invaluable  aid  in  determining  the  value  of  the  machinery.  The 
record  should  show  how  and  when  machinery  is  acquired;  cost, 
including  installation;  amount  reserved  each  year  for  deprecia- 
tion; position  in  factory,  etc. 

There  is  a  tendency  towards  excessive  depreciation  reserves, 
in  the  case  of  certain  machinery  of  which  the  important  parts  can 
be  and  are  renewed  from  time  to  time  and  where  the  cost  of  such 
renewal  is  not  charged  to  the  reserve.  A  manufacturer  who  wants 
to  be  conservative  allows,  say,  15  per  cent  per  annum  on  machin- 
ery. He  may  set  aside  this  rate  for  three  or  four  years  and  make 
no  charges  against  it  for  renewals.  Now,  when  it  is  apphed  to 
any  particular  machine  it  is  apparent  at  once  that  it  is  impossible 
for  the  machine,  so  long  as  it  is  not  obsolete,  to  depreciate  more 
than,  say,  50  per  cent.    In  other  words  the  machine  could  not  be 


I86  AUDITING— GENERAL  PRINCIPLES 

operated  properly  if  it  were  allowed  to  deteriorate  below  50  per 
cent  of  its  normal  condition.  Of  course,  some  machinery  can  be 
operated  fairly  well  for  a  long  time  and  then  go  to  pieces  all  at  once. 
It  is  claimed  that  a  freight  car  can  be  operated  at  70  per  cent  of 
maximum  efficiency  on  its  last  trip  before  it  goes  to  the  scrap  pile. 

There  is  some  basis  of  reason  in  a  factory  manager's  conten- 
tion that  his  plant  is  as  good  as  new.  He  knows  that  every  ma- 
chine is  working  to  its  full  capacity,  and  that  any  considerable 
depreciation  thereof  is  a  physical  impossibihty  or  he  could  not 
produce  a  normal  output.  The  manager,  however,  confuses  de- 
preciation and  efficiency.  There  is,  of  course,  accrued  deprecia- 
tion on  every  machine,  and  this  is  usually  admitted,  sometimes 
after  a  strenuous  argument;  but  the  auditor  who  argues  that  a 
five-year-old  plant  has  depreciated,  say,  50  per  cent,  fails  to 
obtain  a  respectful  hearing.  He  is  told  that,  if  it  were  true,  the 
plant  could  not  be  running,  and  that  fact  seems  to  be  stronger 
than  his  theories. 

The  real  point  at  issue  is  that  a  considerable  reserve  for  ob- 
solescence is  necessary  in  every  plant  where  machine  tools  and 
similar  equipment  are  used.  Depreciation,  as  such,  cannot  ex- 
ceed a  definite  limit,  but  a  machine  which  never  requires  more 
than  30  per  cent  or  40  per  cent  reserve  for  depreciation,  no  matter 
what  its  age  may  be,  should  have  an  obsolescence  reserve  of  per- 
haps as  much  or  more. 

Constant  changes  are  being  made  in  factories  and  mills. 
Machinery  which  is  comparatively  new  is  set  aside  or  discarded 
for  improved  models,  and  this  possibihty  should  influence  the 
auditor  who  passes  upon  the  value  of  such  assets.  In  some  cases 
the  argument  is  advanced  that  the  superseded  machinery  is  as 
good  as  ever  and  is  always  available  in  case  of  emergency  or  a 
sudden  demand  for  an  increased  output.  This  sounds  plausible, 
but  does  not  work  out  well  in  practice.  The  proper  value  to 
place  upon  such  discarded  machinery,  which  may  be  designated 
as  ''reserve plant,"  is  the  nominal  sum  of  $1,  or  else  an  estimated 
usable  value  with  an  offsetting  reserve  to  reduce  it  to  scrap  value. 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  1 87 

Small  Tools. — As  a  rule,  the  practice  of  depreciating  thia 
item  by  means  of  a  percentage  cannot  be  followed  satisfactor- 
ily. So  many  small  tools  are  used  up,  lost,  or  stolen,  that  an 
inventory  should  be  made  at  periodical  intervals  and  all  the 
tools  on  hand  should  then  be  revalued  for  purposes  of  the  bal- 
ance sheet. 

If  this  has  not  been  done,  the  auditor  can  fix  his  valuation  only 
from  the  best  evidence  available,  but  he  should  insist  on  a  mate- 
rial reduction  of  the  book  values,  imless  Hberal  depreciation  has 
been  provided  for. 

Furniture  and  Fixtures 

This  asset  has  little  residual  value.  Conservative  concerns 
charge  off  the  larger  part  of  its  cost. 

In  most  establishments  many  items,  such  as  partitions,  special 
shelving,  etc. ,  are  charged  to  the  fixture  account.  Frequent  altera- 
tions and  changes  are  made.  For  this  reason  most  of  such  ex- 
penditure is  for  repairs  and  should  be  charged  off  currently. 
If  charged  to  an  asset  account,  it  should  be  prorated  over  two  or 
more  years'  operations. 

If  alterations  are  made  in  leased  premises,  the  auditor  must 
be  careful,  if  the  lease  is  about  to  expire,  to  see  that  nothing  is 
carried  as  an  asset  except  movable  fittings,  etc.,  and  that,  if  they 
are  removable,  ample  allowance  is  made  for  deterioration. 

The  auditor  should  not  pass  the  item  of  furniture  and  fixtures 
without  noticing  their  physical  condition.  His  experience  should 
aid  in  determining  the  value  of  this  item  and  he  must  not  be 
induced  to  certify  to  an  overvaluation.  The  amount  of  fire  insur- 
ance carried  thereon  should  be  ascertained.  Fixtures  attached 
to  buildings  should  be  insured  as  buildings,  not  as  movable  fix- 
tures.   This  may  be  an  important  point. 

Containers 

In  certain  lines  of  business,  such  as  breweries,  milk  depots, 
spring- water  dealers,  bakers,  etc.,  a  considerable  number  of  con- 


1 88  AUDITING— GENERAL  PRINCIPLES 

tainers,  such  as  casks,  kegs,  bottles,  cases,  cracker  tins,  etc.,  art 
owned,  and  used  for  transportation  purposes  only,  and  are  sup- 
posed to  be  returned  when  empty.  At  balancing  time  an  accur- 
ate inventory  should  be  taken,  if  possible;  but  if  not  possible,  the 
auditor  must  make  his  own  calculations  as  to  the  number  required 
for  the  normal  operation  of  the  business.  He  should  then  inspect 
the  reserve  supply  and  decline  to  certify  to  a  greater  number  than 
is  thus  disclosed,  unless  furnished  with  imquestioned  proof  that  a 
larger  quantity  exists. 

In  many  cases  concerns  go  on  the  assumption  that  all  such 
containers  are  in  the  possession  of  someone  who  will  return  them 
in  due  course,  but  experience  proves  that  a  considerable  percent- 
age is  lost,  broken,  or  stolen,  and  that  to  carry  these  as  stock  on 
hand  is  to  misstate  the  facts. 

Deposits  of  cash  are  frequently  received  as  security  for  the 
return  of  containers.  The  aggregate  of  such  deposits  may  be 
large.  If  so,  the  auditor  should  note  the  relation  of  this  Kability 
to  the  cash  on  hand.  The  deposits  constitute  a  trust  fund  and 
should  not  be  used  for  working  capital,  although  it  is  hardly  neces- 
sary to  keep  a  separate  bank  account  therefor.  Large  quantities 
of  containers  might  be  billed  with  the  understanding  that  refunds 
would  be  made  on  the  return  of  the  containers.  If  large  sums  had 
been  collected  from  such  billings  and,  due  to  a  fall  in  prices  or 
some  other  reason,  many  containers  were  returned  during  a  short 
period,  it  might  seriously  embarrass  the  concern  required  to  make 
such  refimds. 

Horses 

Horses  not  only  become  less  valuable  through  age,  but  de- 
preciate according  to  the  manner  in  which  they  are  worked.  A 
revaluation  on  the  basis  of  the  age  of  the  horses  and  of  the  nature 
of  the  business  is  more  satisfactory  than  is  the  writing  off  of  a 
fixed  percentage  annually.  The  auditor  should,  if  feasible,  count 
the  horses  called  for  by  the  inventory,  although  he  may  be  unable 
to  pass  upon  their  condition. 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  189 

Wagons,  Automobiles,  etc. 

Although  these  depreciate  rapidly,  and  although  the  apparent 
life  of  automobiles  is  short,  yet  it  must  be  realized  that  the  nature 
of  the  items  permits  repairs  to  be  made  which  largely  take  the 
place  of  renewals.  In  the  case  of  an  automobile,  for  instance, 
tires  are  renewed,  the  motor  may  be  replaced,  and  taxicab  com- 
panies may  entirely  rebuild  the  bodies.  Depreciation,  therefore, 
as  distinct  from  repairs  and  renewals,  may  be  a  smaller  factor  than 
is  at  first  apparent.  Of  course,  full  allowance  should  be  made  for 
"accrued"  wear  and  tear,  but  any  such  rate  of  depreciation  for 
taxicabs  as  has  been  advocated,  viz.,  one  based  on  a  Kfetime  of 
three  years,  is  manifestly  excessive  since  many  in  daily  use  are 
four  or  five  years  old. 

The  auditor  should  verify  the  number  in  use  in  order  to  ascer- 
tain that  full  provision  has  been  made  for  those  sold,  exchanged, 
or  scrapped. 

Patterns,  Drawings,  Lasts,  etc. 

These  items  frequently  represent  large  outlays  by  manufactur- 
ing concerns  and  form  a  difficult  class  to  value.  If  they  are  used 
for  stock,  or  regular  output,  their  value  depends  upon  their  life 
and  upon  the  probability  of  renewed  use.  If  acquired  or  made  for 
special  jobs,  their  residual  value  is  small,  and  the  cost  should  have 
been  a  charge  against  the  jobs  themselves.  In  every  case  these 
items  should  be  regarded  with  suspicion,  and  overwhelming  proof 
must  be  adduced  before  passing  any  material  sum  on  their  ac- 
count as  an  asset.  The  auditor  may  meet  with  strong  opposition 
in  his  efforts  to  reduce  this  item  to  a  reasonable  value,  for  it  repre- 
sents the  skill  and  often  the  affections  of  the  proprietors,  who  dis- 
like to  see  its  value  depreciated. 

However,  the  auditor  must  be  firm  and  must  decline  to  set  up 
sentimental  values  as  tangible  assets.  The  experienced  auditor, 
upon  reflection,  will  recall  the  small  actual  value  which  this  item 
frequently  represents. 

The  facts  are  easily  ascertained.     Public  demands  change, 


190  AUDITING— GENERAL  PRINCIPLES 

and  patterns,  etc.,  must  be  made  to  suit  the  changing  taste. 
Likewise,  the  styles  of  what  appear  to  be  standard  patterns  for 
stable  businesses  change  rapidly.  Engineers  make  about  as 
many  alterations  in  their  **  styles"  as  do  milliners.  When  demand 
ceases,  most  of  the  old  patterns  should  be  scrapped.  This  rule 
applies  to  hardware  designs  as  well  as  to  patterns  for  ladies' 
dresses.  More  than  one  balance  sheet  of  a  hardware  manu- 
facturer or  of  a  maker  of  dress  patterns  shows  a  valuation  placed 
on  designs  which  are  entirely  out  of  favor. 

The  charges  against  this  account  are  usually  cumulative,  i.e., 
they  follow  the  output  almost  automatically,  whereas,  if  any  con- 
siderable percentage  of  the  old  patterns,  etc.,  were  available  for 
use,  the  additions  to  the  account  would  not  keep  pace  proportion- 
ately with  the  production,  but  would  increase  less  rapidly.  The 
auditor  should  apply  these  tests  before  accepting  the  book  valua- 
tions. 

Wherever  feasible,  he  should  advise  that  a  conservative  course 
be  followed,  such  as  writing  down  the  book  value  to  forced  sale 
value. 

Electrotypes,  Woodcuts,  etc. 

The  arguments  just  urged  as  to  patterns  apply  equally  to 
these.  Conservative  publishers  charge  off  almost  the  entire  cost 
of  plates  as  a  direct  cost  of  a  first  edition,  and  they  are  careful 
to  revalue  the  balance  of  the  account  frequently.  If  a  book  or 
other  publication  is  successful,  the  cost  of  plates,  etc.,  can  be 
readily  absorbed  in  its  cost,  but  if  it  is  not  successful,  no  reorders 
can  be  looked  for  and  it  would  be  folly  to  carry  the  plates  in  the 
balance  sheet  at  any  valuation  except  as  scrap  metal.  A  number 
of  bankruptcies  have  occurred  in  the  publishing  business  through 
disregard  of  the  uncertain  value  of  such  assets. 

Patents 

Patents  are  granted  in  this  country  for  a  term  of  seventeen 
years,  so  that  in  the  case  of  valuable  patents  a  proportionate 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  191 

part  of  their  cost  should  be  amortized  or  charged  off  periodically 
in  order  to  write  off  the  entire  cost  before  the  date  of  expiration. 
The  cost  of  patents  ascertained  to  be  of  no  commercial  value 
should  be  written  off  immediately. 

In  many  cases  a  residual  value  remains  which  merges  into 
good- will  in  connection  with  the  handling  of  a  patent;  but  this 
is  a  different  kind  of  asset,  and  the  auditor  is  not  justified  in 
anticipating  such  outcome,  thus  ignoring  the  diminishing  period 
of  protection  or  monopoly.  Other  instances  of  depreciation  of 
patents  are  obsolescence,  the  impossibihty  of  making  the  article 
a  commercial  or  workable  success,  and  failure  to  induce  the  public 
to  buy  the  article.  It  does  not  follow,  therefore,  that  a  patent 
remains  valuable  during  its  whole  life,  and,  if  it  does  not,  revalua- 
tion should  be  resorted  to  except  in  special  cases  when  it  appears 
to  be  justifiable  not  to  write  them  off  and  the  reason  therefor  is 
shown  in  the  balance  sheet. 

It  is  not  unusual  to  find  that  the  cost  of  patents,  improvements 
therein,  and  experimental  work  in  connection  therewith  are  per- 
manently capitalized,  under  the  theory  that  there  is  a  continuing 
value  which,  it  is  assumed,  will  not  diminish  ratably  with  the 
effluxion  of  time.  It  is,  however,  not  good  accounting  practice  to 
adopt  such  a  basis  with  any  asset  whose  useful  life  is  or  may 
be  definitely  limited. 

The  question  arises :  Should  expenses  incurred  in  connection 
with  litigation  for  alleged  infringement  be  added  to  the  asset 
value  of  the  patent?  Where  the  outcome  of  the  litigation  tends 
to  strengthen  the  patent  rights,  there  can  be  no  objection  to  the 
addition  of  such  expenses  to  the  asset  value.  When  the  expendi- 
tures are  for  current  protection,  it  is  better  practice  to  write  off 
such  expenditures  as  current  expenses. 

Expenditures  for  additional  patents,  including  improvements 
in  basic  patents,  should  be  capitalized  and  amortized  over  the 
useful  life  of  the  new  patents. 

The  value  of  patents  should  not  be  written  up,  even  though 
it  appears  to  be  much  in  excess  of  the  original  cost.    When  re- 


192  AUDITING— GENERAL  PRINCIPLES 

valuations  are  made  for  tax  purposes,  appreciation  should  be 
separately  shown  in  the  balance  sheet. 

The  auditor  should  see  the  patent  papers,  including  assign- 
ments, or  else  secure  a  certificate  from  the  patent  attorneys  to 
support  the  item. 

The  ledger  caption  of  the  "patents"  account  is  sometimes  the 
nearest  approach  to  evidence  which  is  called  for  or  submitted. 
If  the  ledger  account  has  been  arbitrarily  so  named  to  offset  an 
issue  of  capital  stock,  and  is  not  represented  by  actual  patents 
of  any  value,  the  auditor  should  insist  on  a  renaming  to  accord 
with  the  facts.  He  has  no  more  right  to  certify  to  a  large  asset 
item  of  ''patents,"  where  the  value  is  not  substantiated,  than 
he  has  to  certify  to  any  other  item  the  meaning  of  which  is 
reasonably  clear  to  the  public,  or  which  they  think  is  clear  to 
them. 

As  a  matter  of  fact,  an  auditor  can  form  a  fairly  correct  opin- 
ion regarding  the  value  of  a  patent.  From  a  commercial  point  of 
view,  if  it  is  an  old  one,  past  results  have  a  definite  bearing  on  the 
point.  Pending  litigation  furnishes  another  clue.  If  it  is  a  new 
patent,  an  auditor  is  as  well  qualified  as  anyone  else  to  estimate 
the  outcome  of  the  future.  This  is  not  an  argument  for  placing 
anything  other  than  facts  in  the  written  report,  but  this  good  rule 
does  not  bar  an  auditor  from  discussing  the  matter  with  his  client, 
or  from  stating  his  experience  in  connection  with  the  subject  if 
requested  to  do  so. 

It  is  sometimes  necessary  to  determine  the  cash  value  of  pa- 
tents which  have  been  acquired  in  exchange  for  capital  stock. 
If  a  free  and  active  market  exists  for  the  shares,  it  would  seem 
that  willing  buyers  and  sellers  themselves  are  fixing  a  fair  price 
for  the  patents.  When  the  market  for  the  shares  is  not  a  free 
market,  other  evidence  must  be  secured  to  fix  the  valuation.^ 


*  The  following  ruling  by  the  Treasury  Department  indicates  its  method 
of  fixing  values  for  tax  purposes: 

"In  the  case  of  inventions,  their  value  is  dependent  upon  proven  utility 
or  the  likelihood  of  practical  usefulness  and  therefore  stock  issued  thereon  will 
have  a  corresponding  value.     If  an  inventor  should  sell  a  recently  patented 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  193 

When  an  appraisal  is  made  or  patents  change  hands,  it 
must  be  remembered  that  applications  for  patents  may  have 
the  same  value  as  patents  which  have  been  issued.  This  is 
an  important  point  in  determining  values  as  of  a  past  date,  be- 
cause the  term  of  protection  is  extended.  If  a  valuable  patent 
was  issued  March  i,  191 5,  and  was  applied  for  March  i,  1913, 
the  amount  to  be  written  off  annually  is  one-nineteenth  of  the 
March  i,  1913  value,  because  the  expiration  date  is  March  i, 
1932. 

A  possible  argument  against  this  plan — based  on  expediency — 
is  that  the  plan  proposed  can  be  applied  only  retroactively.  In 
other  words,  the  period  over  which  the  cost  or  value  of  a  patent  is 
to  be  written  off  cannot  be  known  until  the  patent  is  granted,  since 
the  period  which  may  elapse  between  date  of  application  and  date 
of  granting  the  patent  is  uncertain.  Hence  the  argument  has 
been  advanced  that  there  is  no  necessity  for  writing  off  any  por- 
tion of  the  patent  cost  or  value  until  the  actual  granting  of  the 
patent,  as  it  is  only  then  that  a  limitation  on  the  life  of  the  patent 
is  imposed.  This  view  of  the  situation  facilitates  the  writing  off 
of  annual  allowances  for  exhaustion  of  the  patent  cost  or  value, 
and  obviates  the  need  for  any  retroactive  adjustment  upon  grant- 
ing of  a  patent.  This  practical  consideration,  however,  is  really 
the  only  argument  to  be  made  for  the  last  suggested  method.  In 
principle,  the  spreading  of  the  cost  or  value  over  the  entire  period 
elapsed  between  application  for,  and  the  expiration  of,  a  patent  is 
the  more  accurate  method. 


invention  to  a  manufacturer  before  its  use  has  been  tested,  but  simply  upon  its 
apparent  usefulness,  it  may  be  said  that  the  invention  at  that  time  is  worth 
what  is  paid  for  it,  because  a  price  has  been  offered  and  paid.  The  measure 
of  value  is  the  price  paid.  .  .  .  Stock  issued  upon  such  invention  would  be 
worth  the  value  of  the  invention,  measured  by  the  price  which  the  manufac- 
turer has  paid  for  it. 

"Where  the  inventor  himself  forrns  a  company  and  issues  stock  upon  his 
invention  and  there  are  dealings  in  said  stock  at  or  within  a  reasonable  time 
after  the  issuance  thereof,  prices  then  paid  may  be  said  to  be  evidence  of  the 
value  of  the  invention  capitalized  and  therefore  of  the  stock  at  the  time  of  its 
issuance.  This  is  upon  the  principle  that  a  subsequently  existing  fact  is  evi- 
dence of  some  probative  value  of  the  prior  existence  of  the  same  fact.  ,  .  ," 
(Solicitor's  Law  Opinion  962,  Cumulative  Bulletin  No.  2,  page  74.) 

VOL.  I — 13 


194  AUDITING— GENERAL  PRINCIPLES 

Copyrights 

The  same  considerations  that  apply  to  patents  apply  also  to 
copyrights,  except  that  in  the  case  of  copyrights  the  term  is  28 
years,  which  term,  under  certain  circumstances,  may  be  renewed 
for  another  28  years.  As  most  copyrights  diminish  steadily  in 
value,  depreciation  should  not  be  based  on  their  hfe,  but  upon 
revaluation  at  stated  intervals. 

Revaluation  of  each  one  is  the  only  satisfactory  solution.  In 
all  cases  the  auditor  should  be  furnished  with  a  list  of  copyrights 
owned.  Inquiry  based  on  this  Hst  will  develop  evidence  as  to  the 
actual  worth  of  the  asset. 


CHAPTER   XI 
BALANCE  SHEET  AUDIT— FIXED  ASSETS  (Continued) 

GOOD-WILL 

This  asset  is  in  a  class  by  itself.  The  term  ''good- will "  when 
it  appears  in  a  balance  sheet  represents  the  stated  value  attached 
to  the  business  over  and  above  the  value  of  the  other  stated 
assets.  ^  It  is  such  an  intangible  and  elusive  asset  that  it  is  not 
subject  to  wear  and  tear,  and  the  principles  of  depreciation  cer- 
tainly cannot  be  appHed  to  it  as  to  other  items.  If  earnings  de- 
cline for  any  reason,  except  of  the  most  temporary  character,  the 
value  of  good-will  declines  correspondingly,  because  by  its  very 
nature  its  value  depends  on  earnings  of  a  certain  amount  being 
maintained.  The  element  of  earnings  is  not  always  insisted  upon 
in  cases  of  old-estabHshed  businesses  which  are  believed  to  be 
inefficiently  managed.  Good-will,  however,  always  appears,  or 
should  appear,  on  the  balance  sheet  as  a  separate  item,  and  well- 
established  practice  permits  it  to  appear  at  cost,  irrespective  of 
fluctuations  in  its  value.  Any  gain  can  only  be  determined  by 
sale;  a  decline  in  value  can  be  determined  more  accurately.  It 
might  be  claimed,  and  rightly,  that  purchases  of  capital  stock  at  a 
price  above  the  book  value  are  the  best  evidence  of  the  value 
placed  upon  good- will  by  disinterested  persons;  true,  but  its 
actual  value  changes  from  day  to  day,  and  there  is  so  much  un- 
certainty in  any  attempt  to  adjust  its  book  value  that  by  common 
consent  it  is  usually  left  alone,  except  when  earnings  are  unusu- 
ally large,  and  it  is  therefore  considered  advisable  to  write  it  off. 

In  a  few  cases  good-will  has  been  written  up,  surplus  credited, 
and  a  large  stock  dividend  paid.    The  author  has  seen  an  opinion 


^  For  methods  of  arriving  at  the  value  of  good-will  for  tax  purposes,  see 
Income  Tax  Procedure,  1921,  pages  412-419. 

195 


196  AUDITING— GENERAL  PRINCIPLES 

written  by  one  of  the  country's  most  prominent  lawyers  advising 
that,  on  the  ground  that  over  a  period  of  years  the  corporation 
had  earnings  far  in  excess  of  normal  earnings  on  its  capital,  a 
good- will  had  been  created  which  it  was  possible  to  value.  The 
very  existence  of  earnings  sufficient  to  write  it  off  justifies  its  re- 
tention; whereas  earnings  that  are  not  up  to  expectations,  and 
are  insufficient  to  enable  a  concern  to  write  it  off,  indicate  that  its 
book  value  is  inflated.  As  good-will  does  not  suffer  from  wear  and 
tear,  does  not  become  obsolete,  and  is  not  used  up  in  the  opera- 
tion of  the  business,  depreciation  cannot  be  charged  against  it. 
When  it  is  written  off,  a  secret  reserve  may  result,  and  therefore 
no  objection  can  be  offered  to  its  retention  at  cost. 

The  intangible  nature  of  good-will  has  made  it  an  easy  sub- 
ject of  manipulation.  Not  long  ago  an  able  judge  held  that  the 
use  of  the  term  ''good-will"  to  describe  overvaluations  had  been 
sadly  overdone.  In  the  case  at  issue,  stocks  and  bonds  had  been 
issued  to  owners  for  their  several  enterprises  and  it  was  obvious 
that  such  payments  included  as  much  good-will  as  could  possibly 
be  ascribed  thereto,  and  that,  further,  large  blocks  of  stocks  and 
bonds  issued  to  the  promoters  for  "services"  constituted  over- 
issues. He  also  said  that  the  dummy  directors  who  solemnly 
voted  that  the  properties  acquired  were  worth  the  price  fixed  by 
the  promoters  were  neither  competent  to  pass  thereon  nor  in- 
dependent enough  to  make  their  decision  binding.  Contempor- 
ary sales  of  stock,  if  the  market  is  a  free  one,  are  of  greater  weight 
in  determining  value  than  are  appraisals. 

Earnings  the  Principal  Factor  of  Value 

Although  good-will  is  said  to  be  the  attractive  force  which 
secures  custom,  an  erroneous  idea  sometimes  obtains  with  respect 
to  a  business  which  has  not  earned  more  than  an  equivalent  of  an 
average  rate  of  interest  on  invested  capital,  plus  a  reasonable 
allowance  for  proprietor's  compensation.  It  is  not  enough  that 
such  a  business  be  long  established  and  have  a  good  fine  of  cus- 
tomers; that  prompt  service  and  courteous  treatment  have  given 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  197 

prestige  to  the  trade-name;  that  brands  or  trade-marks  have 
become  household  words;  that  the  location  is  ideal  and  can  be 
continued,  and  that  other  equally  attractive  factors  are  present. 

In  fact,  these  elements  are  negative  rather  than  affirmative 
circumstances  for  the  consideration  of  a  prospective  buyer, 
because  they  leave  but  Httle  opportunities  for  betterment.  If  the 
business  has  not  shown  satisfactory  or  increasing  profits  under 
ideal  conditions,  how  can  a  purchaser,  who  usually  works  at  a  dis- 
advantage as  compared  with  his  predecessor,  hope  to  increase  the 
profits  to  a  point  which  will  equal  those  of  the  old  business  and 
also  yield  a  further  return  upon  an  additional  cash  investment  in 
good- will? 

To  have  a  sales  value,  good-will  must  represent  a  substantial 
earning  power  in  excess  of  ordinary  interest  on  capital  and  mana- 
gerial salaries  combined.  There  may  be  a  lot  of  sentiment  at- 
tached to  an  old  business,  but  a  losing  business  does  not  possess 
any  good-will  unless  there  are  obvious  signs  of  mismanagement. 
The  plea  of  bad  management  is  overworked  and  is  too  frequently 
believed  to  be  a  conclusive  cause  of  failure.  Then,  too,  profits 
should  be  increasing.  If  the  business  is  standing  still,  the  danger 
of  going  backwards  is  greater  than  is  the  likelihood  of  improve- 
ment. There  is  no  certainty  that  exceptionally  profitable  past 
years  which  serve  to  increase  the  average  profits  over  a  period  of 
years,  can  be  repeated. 

Formula  for  Determining  Value 

The  usual  formula  for  determining  the  value  of  good-will  is  as 
follows :  Take  the  average  net  profits  for  a  term  of  years,  deduct 
interest  on  net  tangible  capital  employed;  deduct  the  value  (not 
necessarily  the  amoimt  paid)  of  manager's  (one  or  more)  com- 
pensation; the  balance  represents  the  amount  of  profits  which 
may  be  said  to  be  attributable  to  good-will. 

In  fixing  compensation  for  management,  consider  the  class  of 
business — stable  or  hazardous;  general  or  special  training,  ex- 
perience and  ability  required  to  conduct  it;  general  standard  of 


198  AUDITING— GENERAL  PRINCIPLES 

salaries  in  a  similar  business  or  in  a  business  producing  a  similar 
amount  of  profit. 

Illustrations  of  Methods  Used  in  Determining  Values. 
— In  the  formation  of  the  International  Harvester  Company,  the 
original  contract  provided  that  the  good-will  value  of  the  con- 
soHdating  units  should  be  fixed  at  the  sum  of  the  profits  of  the 
two  preceding  years,  plus  an  additional  lo  per  cent.  In  comment- 
ing thereon,  the  United  States  Commissioner  of  Corporations 
stated:  "This  method  of  valuing  good-will  was  more  or  less 
commonly  used  among  manufacturers."  Further  on  in  the 
comment,  a  decided  modification  of  the  rule  appears: 

However,  the  method  of  determining  the  net  profits  was  specifically 
prescribed  in  such  a  manner  as  to  give  a  much  larger  amount  of  profit 
than  that  shown  by  the  companies'  profit  and  loss  accounts.  That  is, 
certain  kinds  of  income  and  expenditure  were  not  included  in  the  computa- 
tion, as,  for  example,  interest  on  accounts  and  bills  receivable  and  interest 
on  certain  accounts  payable,  and  cost  of  collecting  receivables.  Further- 
more, although  the  above  mentioned  contracts  provided  that  depreciation 
should  be  deducted  from  profit,  whether  on  account  of  plant,  materials  of 
manufacture,  or  of  bills  and  accounts  receivable,  yet  in  the  computation 
made  of  good-will  value  by  the  accountants  such  depreciation  was  not 
deducted.  The  final  net  profit  as  fixed  by  the  accounts  was  not  used, 
therefore,  in  this  appraisal  of  good-will,  but  instead  a  considerably  higher 
amount  of  profit  with  a  corresponding  enhancement  of  the  estimated  value 
of  good-will. 

Comments  by  the  United  States  Bureau  of  Corporations  with 
respect  to  good-will  are  of  interest.  The  following  quotations 
are  from  its  reports  on  various  industries : 

There  are  great  differences  in  respect  to  good-will  between  different 
kinds  of  business.  The  most  important  difference,  probably,  is  that  be- 
tween companies,  on  the  one  hand,  which  sell  a  staple  product  which  is 
bought  and  sold  under  its  staple  name  without  respect  to  the  producer,  and 
companies,  on  the  other  hand,  which  sell  an  article  under  a  trade-name 
which  is  always  bought  with  the  knowledge  either  of  the  name  of  the  par- 
ticular producer  or  of  the  brand  name  under  which  the  article  is  sold.    The 


BALANCE  SHEET  AUDIT— FIXED  ASSETS 


199 


/ 

J  "eOOD-WILL"! 

\ 

coMPcrmoN 

PD?SONNEL 

PENDING  0PDD2S 

PUBLICITV 

1 

1 

1 

1 

WVTENT  PI6HTS 

TPADE  NAMES 

FBANCHISE5 

CREDIT 

1 

1 

1 

1 

REPUTATION  FOC 
ir^fTCGBITY 

CONOTION  OF 
MACKET 

ESTABLISHED 
LOCATION 

ANNUAL 
EARNINGS 

Some  of  the  factors  that  enter  into  a  computation  of  the  "good  will"  of  a 
business.  For  obvious  reasons  these  factors  vary  greatly  in  importance,  depen- 
dent upon  the  peculiar  conditions  that  aflfect  the  Business  that  enters  into  the 
transaction. 


MULTIPLES  BY  WHICH  GOOD-WILL  HAS  BEEN  ESTIMATE^  BASED  ON  EARNINGS 

Surplus  Profit-5  fbr 
One\feer 

Usual  Estimate  of 
•Good-Wiir 

fbr  Professional 
Practice 

lor  ManuTacturing 
Business 

Fbr  Wholesale  or  Be- 
tail  Trading  Business 

1 

1 

1    1    1 

fbr  Quasi  Monopoly 
or  Similar  Business 

for  Established 
Monopolies 

1 

1    1 

+ 

J 

The  first  rule  in  computing  "good^will"  is  to  determine  the  net  earnings  of 
a  business,  from  which  sum  is  deducted  the  interest  on  capital  actually  employed 
and  the  value  of  the  owner's  services.  The  result,  multiplied  ordinarily  by  two 
but  sometimes  by  many  times  that  amount,  has  been  accepted  as  the  value  of  the 
"good-will." 

Note. — The  above  charts  are  reproduced  by  permission  from  System  for 
January,    1912. 


200  AUDITING— GENERAL  PRINCIPLES 

latter  kind  of  article  is  generally  advertised  under  its  trade-name,  and  if 
the  business  is  successful  and  expanding  it  has  a  wide  custom,  of  which 
the  concern  making  it  cannot  be  quickly  deprived  in  the  ordinary  course  of 
trade,  even  by  more  efficient  competitors. 

General  conditions  of  trade  may  undergo  such  changes  that  a  business 
once  profitable  may  become  comparatively  unprofitable.  The  opportuni- 
ties for  successful  business  operation  may  in  time  be  pretty  well  exhausted, 
either  because  the  needs  of  consumers  are  so  well  supplied  for  a  long  time 
ahead  that  demand  slackens,  or  because  of  other  changes  in  the  trade. 
Again,  good-will  based  on  trade-name  and  custom  may  be  lost  to  some 
extent  if  for  any  special  reason  the  article  of  a  certain  maker  acquires 
suddenly  an  unfavorable  notoriety.  In  this  class  of  conditions  there  is  no 
doubt  that  the  so-called  anti-trust  sentiment  is  an  important  example. 

Undoubtedly  there  is  a  legitimate  value  attaching  to  good-will  in  the 
tobacco  business,  that  justifies  either  valuation  in  excess  of  the  tangible 
assets  or  a  rate  of  income  on  tangible  assets  greater  than  the  ordinary  rate 
of  business  profits  in  enterprises  where  good-will  is  not  an  important  factor. 

The  element  of  good-will  in  the  tobacco  business  consists  chiefly  of 
what  may  conveniently  be  termed  "brand  value."  At  present  nearly  all 
manufactured  tobacco,  in  whatever  form,  is  sold  under  some  special  brand 
name.  By  means  of  extensive  and  skilful  advertising,  by  a  superior  com- 
bination of  qualities,  or  sometimes  merely  by  some  good  fortune  not  easily 
explained,  certain  brands  of  tobacco  have  acquired  a  degree  of  popularity 
which  gives  them  a  marked  advantage  over  other  brands  and  which  even 
under  competitive  conditions  enables  the  manufacturer  to  realize  a  profit 
unusually  high,  and  sometimes  extraordinarily  so.  Demand  for  particular 
brands  of  tobacco  is  based  peculiarly  on  individual  taste  or  desire  formed 
into  a  fixed  preference.  This  preference  may  have  been  developed  and 
fostered,  of  course,  through  various  forms  of  advertising  and  other  schemes 
and  inducements  by  the  manufacturer.  It  may  not  necessarily  be  due  to 
any  well-defined  intrinsic  qualities  in  the  brands,  although  a  permanent 
demand  for  a  particular  brand  must  be  more  or  less  based  upon  actual 
valuable  qualities  possessed  by  it.  Brands  of  manufactured  tobaccos  in 
this  respect  are  like  many  other  so-called  proprietary  articles — patent 
medicines,  perfumes,  liquors,  toilet  preparations,  chewing  gum,  etc. — 
the  manufacturers  of  which  may  and  often  do  make  exceptional  profits. 

FUND  ACCOUNTS 

The  caption,  ''sinking  fund,"  or  any  other  fund  account, 
should  always  represent  an  asset,  and  inquiry  should  always  be 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  201 

made  (whenever  the  nature  of  the  undertaking  causes  the  ques- 
tion to  be  raised)  as  to  the  disposition  of  this  account. 

Sinking  Funds 

In  many  mortgages,  especially  when  secured  by  coal,  ore, 
lumber,  etc.,  it  is  provided  that  a  certain  amount,  based  on  the 
production,  shall  be  paid  to  trustees  for  the  purpose  of  extinguish- 
ing the  debt  at  or  before  maturity.  These  amounts  properly 
appear  as  assets,  on  the  balance  sheet,  and  it  should  be  clearly 
shown  what  investments  have  been  made  and  what  cash,  if  any, 
remains  uninvested. 

In  theory  this  principle  is  not  affected  by  the  fact  that  some 
sinking  funds,  instead  of  being  actual  assets,  are  deductions  from 
liabilities.  For  instance,  a  sinking  fund  may  be  used  to  buy  up  a 
corporation's  own  bonds.  The  actual  condition  is  better  ex- 
pressed if  the  bonds  so  held  (and  which  may  be > canceled)  are  de- 
ducted from  the  total  outstanding  bonds,  rather  than  if  shown  as 
an  asset. 

A  certificate  from  the  trustees  as  to  the  state  of  the  fund  is 
sufficient  evidence  for  the  auditor,  in  so  far  as  the  examination  of 
the  cash  and  securities  is  concerned. 

If  the  bonds  have  been  surrendered  to  the  company,  the  audi- 
tor should  examine  them  and  note  whether  proper  safeguards  are 
provided  to  prevent  improper  use  thereof. 

The  creation  of  sinking  funds  and  other  points  in  connection 
therewith  are  discussed  on  page  284. 

Conditions  Imposed  by  Creditors. — In  practically  all  cases 
of  recent  issues  of  preferred  stocks  and  short-term  bonds  and 
notes,  provision  is  made  for  the  creation  of  sinking  funds  to  retire 
all  or  a  certain  percentage  of  the  stocks  or  obligations.  Some- 
times the  sinking  fund  instalments  are  paid  to  trustees;  in  other 
cases  the  debtor  corporations  covenant  to  carry  out  the  pro- 
visions. In  the  case  of  bonds  and  notes,  any  default  may  result 
in  the  entire  issue,  upon  demand  by  a  certain  percentage  of  credi- 


202  AUDITING— GENERAL  PRINCIPLES 

tors,  being  declared  due  and  payable.  Since  preferred  stock  is 
not  a  liability  there  can  be  no  enforced  liquidation  in  the  case  of 
default,  but  other  results,  such  as  changes  in  the  composition  of 
the  board  of  directors,  may  ensue. 

The  provisions  vary  with  the  ingenuity  of  lawyers  and  accoun- 
tants; in  each  trust  deed  there  are  provisions  which  are  intended 
to  safeguard  the  investors  in  that  particular  corporation.  In  each 
case  the  auditor  must  secure  a  copy  of  such  agreements,  be  guided 
by  their  terms,  and  use  his  own  judgment  in  commenting  upon 
compliance  with,  or  default  in,  the  terms. 

Funds  Representing  Investments  of  Reserves 

It  is  not  customary  to  invest  reserves  in  specific  assets.  Theor- 
ists feel  strongly  that  an  amount  equal  to  a  reserve  account 
created  for  a  specific  purpose  should  be  invested  in  first-class 
securities,  so  that  it  will  be  available  when  it  becomes  necessary 
to  spend  the  cash  required  to  make  good  the  asset  for  whose  re- 
placement the  reserve  was  set  up. 

The  theory  is  tenable  if  the  reserve  represents  the  depreciation 
of  a  specific  thing,  such  as  a  building  or  a  ship,  and  if  it  is  the 
intention  to  replace  the  building  or  ship  after  its  usefulness  has 
ended.  But  most  buildings,  ships,  and  similar  assets  are  parts 
of  general  holdings  and,  with  rare  exceptions,  more  profitable  use 
of  the  fund  can  be  made  in  the  purchase  of  new  property  or  in 
extensions  or  additions  to  existing  plant,  than  in  the  purchase  of 
stocks  or  bonds  of  other  enterprises.  In  fact,  almost  the  only 
argument  against  the  use  in  one's  own  business,  of  funds  repre- 
senting reserves  is  the  temptation  to  expand  beyond  safe  limits; 
but  this  depends  not  so  much  on  the  cash  in  hand  as  on  the  ability 
to  borrow.  In  other  words,  the  man  who  desires  to  expand  usu- 
ally does  so  to  the  extent  of  his  borrowing  limit,  and  it  is  futile  to 
suggest  to  him  the  desirability  of  investing  funds  which  represent 
reserves,  in  outside  securities. 

If  an  auditor  finds  that  a  fund  exists  representing  investments 
of  reserves,  the  securities  in  it  and  any  income  therefrom  should 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  203 

be  verified  in  the  usual  way.  If  the  amounts  reserved  are  suffi- 
cient to  accumulate  to  the  desired  aggregate  without  interest 
being  added,  any  income  realized  from  them  should  be  credited 
to  profit  and  loss;  but  if  both  accumulations  and  reinvested  in- 
come are  being  relied  upon  to  add  to  the  fund  itself,  the  auditor 
should  ascertain  whether  the  net  income  collected  is  sufficient  for 
that  purpose. 

Fund  and  Other  Permanent  Investments 

In  this  class  are  included  the  securities  held  for  income  pur- 
poses, or  as  investments  of  sinking,  reserve,  and  other  special 
funds. 

The  element  of  permanency  arises  from  the  purpose  of  the 
investments,  i.e.,  they  are  neither  bought  and  sold  with  a  view  to 
profit  in  their  turnover,  nor  are  they  held  as  a  temporary  reserve 
to  be  instantly  converted  into  cash. 

In  many  instances  the  market  price  at  a  particular  date  may 
be  fixed  by  a  few  small  transactions  which  have  little  bearing  on 
actual  values,  owing  to  the  limited  demands,  and  perhaps  to  an 
urgent  necessity  to  sell  on  the  part  of  an  unfortunate  investor. 
The  proper  plan  of  valuing  bonds  purchased  for  permanent  in- 
vestment is  to  compute  their  value  on  the  basis  of  the  effective,  or 
actual,  rate  of  interest,  if  held  to  maturity.  The  basis  to  be  used 
is  the  prices  at  which  they  were  originally  purchased. 

Bonds  are  rarely  purchased  at  their  par  or  face  value.  To 
make  the  amount  of  the  purchase  equal  the  par  value  at  maturity 
requires  an  adjustment  of  accounts.  The  scientific  method  of  ad- 
justment is  known  as  amortization  or  accumulation  and  involves 
a  debit  or  credit  to  interest  account  at  each  periodical  adjustment 
of  the  book  value,  in  accordance  with  the  effective  rate  of  interest, 
on  the  basis  of  which  the  investment  was  made. 

The  corporations  in  whose  balance  sheets  marketable  invest- 
ments play  a  leading  part  are:  insurance  companies,  banks  (more 
particularly  savings  banks),  and  trust  companies.  State  laws 
require  that  the  solvency  of  insurance  companies  be  tested  by  the 


204  AUDITING— GENERAL  PRINCIPLES 

adequacy  of  the  assets  (valuing  stocks  and  bonds  at  the  market 
prices)  to  meet  the  present  value  of  policy  contracts  in  force  and 
sundry  other  habilities.  Owing  to  the  abnormal  decline  in  the 
market  values  of  securities  in  the  fall  of  1907,  and  again  at  the 
end  of  1920,  the  statements  of  almost  all  the  life  insurance  com- 
panies as  at  December  31,  1907,  and  1920,  showed. startling  de- 
creases in  surplus  as  compared  with  their  statements  as  at  the 
close  of  the  preceding  years.  This  shrinkage  attracted  consider- 
able attention,  and,  since  the  corporate  bonds  owned  (the  fall  in 
whose  market  quotations  was  largely  responsible  therefor)  were 
yielding  the  same  rate  of  income  as  when  purchased,  there  was 
no  serious  question  as  to  the  security  of  the  principal  of  most  of 
them,  and  as  they  were  purchased  to  be  held  until  maturity, 
emphasis  was  given  to  the  question,  whether  the  basis  of  so- 
called  market  value  was  not  erroneous.  These  object  lessons 
have  resulted  in  a  more  general  appreciation  of  the  advantages  of 
amortization.  A  professional  auditor  should  be  fully  conversant 
with  the  principles  of  amortization  and  should  recommend  its 
adoption  wherever  conditions  warrant  it. 

In  preparing  a  balance  sheet  which  is  to  show  investment 
securities  at  their  amortized  values,  it  is  interesting  and  advisable 
to  mention,  in  a  footnote  or  other  suitable  place,  the  market 
values  as  at  the  date  of  the  balance  sheet. 

If  securities  are  purchased  for  a  definite  purpose,  such  as  the 
creation  of  a  fimd  to  retire  maturing  obligations,  the  questions  of 
income  and  of  amortization  are  both  important.  In  all  cases  the 
auditor  should  secure  a  copy  of  the  board  minutes  or  trust  deed 
provisions  which  govern  the  setting  aside  and  handling  of  the 
fund.  Any  variation  therefrom  may  be  important  and  should  be 
fully  investigated.  * 

If  the  balance  sheet  does  not  disclose  the  fund  properly,  the 
auditor  must  insist  on  its  correction.  Many  corporate  officers 
neglect  sinking  fund  and  similar  requirements  if  the  trustee  fails 
to  inquire  periodically  into  the  transactions  of  the  corporation. 
When  their  omissions  are  called  to  their  attention,  they  point  out 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  205 

the  excellent  financial  condition  of  the  company  and  argue  that 
the  provisions  are  intended  merely  to  safeguard  the  bondholders 
from  loss  in  case  the  company  should  be  unsuccessful,  but,  since 
the  contrary  is  the  case,  there  is  no  necessity  for  bothering  with 
the  setting  aside  and  investing  of  a  sinking  fund. 

Many  bonds  are  secured  by  mortgages  on  personal  property. 
Failure  to  observe  trust  deed  requirements  occurs  most  frequently 
where  there  is  a  sale  of  a  part  of  the  property  pledged  under  a 
mortgage.  When  obsolete  or  worn-out  property  is  sold,  all  pro- 
ceeds of  such  sales  are  the  property  of  the  trustee.  Any  use 
thereof  by  the  corporation  is  conversion. 

Therefore,  wherever  an  auditor  finds  that  there  has  been  an  is- 
sue of  bonds,  he  should  obtain  a  copy  of  the  mortgage  securing  the 
same,  examine  its  provisions,  and  note  any  failure  to  observe  them. 

It  may  be  that  resolutions  can  be  found  in  the  board  minutes 
requiring  the  investment  of  part  or  all  of  the  surplus  in  specific 
securities.    The  requirement  will  not  be  difficult  to  verify. 

Bonds  and  Mortgages 

Bonds  secured  by  mortgages  upon  real  estate  should  be  care- 
fully examined,  as  well  as  the  other  papers  usually  filed  with  them. 
Formerly  such  bonds  were  double  the  face  of  the  mortgage,  the 
reason  being  that  the  mortgage  itself  could  not  be  converted  into 
anything  but  the  real  property  itself,  thus  leaving  accrued  in- 
terest, taxes,  expenses  of  foreclosure,  etc.,  unprovided  for.  By 
requiring  the  mortgagor  to  execute  a  bond  in  a  sum  sufficient  to 
cover  all  such  amounts,  the  result  was  accompHshed.  The  present 
practice  is  to  write  the  bond  for  the  same  amount  as  the  mortgage. 
Provisions  protecting  the  mortgagee  for  interest,  costs,  etc.,  are 
inserted  in  the  bond.  The  mortgage  should  bear  evidence  of 
recording  on  its  face  and  should  appear  to  be  regular  as  to  signa- 
ture, etc.,  and  in  a  general  way  should  be  identified  with  the 
description  contained  in  the  schedule  of  assets. 

Insurance  and  title  poHcies  should  be  submitted,  and  as  a  rule 
accompanied  by  certified  appraisals  by  disinterested  experts.    If 


206  AUDITING— GENERAL  PRINCIPLES 

the  mortgage  is  for  a  long  term,  a  recent  appraisal  should  be  found. 
As  to  renewals,  a  new  appraisal  should  be  secured  unless  good 
reasons  appear  to  the  contrary. 

Instances  are  known  where  canceled  or  fictitious  mortgages 
have  been  submitted  as  outstanding  or  genuine.  A  clever  forger 
caiL  manufacture  documents  which  will  deceive  those  more 
familiar  with  such  papers  than  is  the  average  professional  auditor. 
Fortunately,  it  is  not  often  attempted.  The  scrutiny  by  the  audi- 
tor of  all  the  papers  and  correspondence  usually  accompanying 
mortgages,  and  the  verification  of  the  original  purchase,  and 
collections  of  income  and  principal,  should  disclose  any  irregulari- 
ties. The  verification  of  balance  of  principal  should  be  made  by 
direct  correspondence  with  the  borrower  unless  the  client  does  not 
wish  such  confirmation  made,  in  which  case  the  auditor  should 
qualify  his  report  accordingly.  The  auditor  should  ascertain  that 
paid  tax  bills  have  been  submitted  to  the  mortgagees. 

TREASURY  STOCK 

When  stock  is  issued  fully  paid  and  is  returned  to  the  treasury 
of  the  company  which  issued  it,  through  purchase  or  gift,  it  is 
known  as  ^'treasury  stock."  In  verifying  the  existence  and  loca- 
tion of  treasury  stock  the  same  rules  should  be  observed  as  in  case 
of  other  securities. 

If  the  state  law  permits  the  holding  of  treasury  stock,  the 
acquired  stock  may  be  reissued.  If  the  state  law  prohibits  hold- 
ing of  treasury  stock,  the  acquisition  of  the  stock  automatically 
effects  a  reduction  of  the  capitalization  and  the  stock  cannot  be 
legally  reissued. 

In  states  where  the  right  to  hold  treasury  stock  is  doubtful 
donated  stock  is  sometimes  placed  in  the  names  of  trustees  to  be 
held  by  them  subject  to  the  order  of  the  board  of  directors. 

If  purchased  by  the  corporation  for  resale,  cost  price  is  the 
correct  basis  of  book  entry;  if  purchased  without  specific  inten- 
tion to  resell  and  more  than  par  is  paid,  the  premium  should  be 
charged  to  surplus.    In  effect,  part  of  the  surplus  is  paid  to  the 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  207 


retiring  stockholder,  j  The  par  value  of  the  stock  purchased 
should  be  deducted  on  the  balance  sheet  from  the  total  stock 
issued.  When  the  cost  is  less  than  par,  the  purchase  price  should 
be  carried  in  the  books  and  in  the  balance  sheet  as  an  asset,  but 
the  item  must  not  be  included  among  any  other  assets^]  It  is 
desirable  that  the  number  of  shares  should  be  stated.  It  is  infor- 
mation which  should  be  revealed.  Many  published  balance 
sheets  do  show  all  details,  but  the  practice  is  not  uniform. 

If  acquired  by  gift,  opinions  differ  as  to  the  form  of  entry. 
Because  of  the  legal  formaUties  required  to  show  that  the  stock 
has  been  issued  full-paid,  the  best  authorities  sanction  the  setting 
up  of  the  stock  as  an  asset  at  par  value,  offsetting  this  entry  by 
the  creation  of  a  reserve  or  surplus  account  which  is  designated  as 
a  capital  item,  and  which  is  clearly  differentiated  from  the  surplus 
which  arises  out  of  profits  or  which  is  available  for  dividends.* 
It  is  never  proper  to  include  any  part  of  the  book  value  of  treasury 
stock  among  the  current  profits  or  as  a  part  of  the  surplus  avail- 
able for  dividends.  This  does  not  apply,  however,  if  stock  had 
been  resold  at  a  profit  and  the  profit  is  realized  in  cash.  As 
treasury  stock  is  sold  or  otherwise  disposed  of,  the  asset  account  is 
credited  and  an  adjustment  is  made  between  this  account  and  the 
reserve  or  surplus  account  for  the  difference  between  the  book 
value  and  the  proceeds  of  the  sale. 

It  would  be  more  accurate  to  enter  donated  stock  as  a  credit 
at  par  to  the  property  or  other  asset  account  which  was  debited 
when  the  stock  was  originally  issued,  and  to  debit  treasury  stock. 
In  setting  up  the  accounts  on  a  balance  sheet,  treasury  stock 
would  be  deducted  from  the  total  stock  issued.  If  any  stock  is 
sold  at  par,  no  adjustment  is  necessary;  if  sold  for  more  than  par, 
the  premium  received  should  be  credited  to  capital  surplus;  if 
sold  for  less  than  par,  an  account  called  ^'discount  on  capital 
stock"  should  be  debited.  The  foregoing  procedure  is  not  fea- 
sible under  the  corporation  laws  of  states  which  require  stock  to 


*  For  a  full  discussion  of  treasury  stock,  see  Accounting — Theory  and 
Practice  by  R.  B.  Kester. 


V 


208  AUDITING— GENERAL  PRINCIPLES 

appear  as  full-paid.  Entries  which  negative  this  showing  should 
not  be  made  without  the  approval  of  competent  legal  advisers. 
Fortunately,  ''no-par"  value  capital  stock  can  now  be  issued  in 
many  states  and  the  necessity  for  padded  book  entries  is  obviated. 

In  the  case  of  no-par  value  shares  properly  issued  and  donated 
to  the  corporation,  treasury  stock  should  be  debited  for  $i  and 
capital  surplus  credited.  Any  cash  reaUzed  from  sales  should  be 
credited  to  capital  surplus,  unless  the  stock  originally  was  issued 
for  property  and  the  property  was  overvalued,  in  which  case  the 
credit  should  be  to  the  property  account. 

When  no-par  value  treasury  stock  is  acquired  at  a  price  less 
than  the  original  issue,  some  authorities  state  that  surplus  should 
be  credited  with  the  difference  between  the  purchase  price  and 
book  value.  If  original  book  value  was  $40  per  share  and  1,000 
shares  are  purchased  at  $30  per  share,  surplus  would  be  credited 
with  $10,000,  under  the  theory  that  original  values  should  not  be 
disturbed.  The  simplest  method  is  to  carry  the  stock  at  cost. 
Nothing  has  happened  to  justify  a  credit  to  surplus;  on  the  con- 
trary the  only  change  in  the  situation  is  that  someone  is  willing 
to  sell  stock  at  less  than  book  value,  thus  discrediting  asset  valua- 
tions. An  accurate  reflection  of  the  transaction  (if  the  books  are 
to  be  readjusted)  is  to  reduce  the  original  property  values.  When 
sales  have  been  made  by  a  seller  under  compulsion  to  sell  for 
reasons  not  connected  with  the  company  whose  stock  he  is  selling, 
it  cannot  be  said  that  values  are  discredited;  where  there  are 
willing  sellers  as  well  as  willing  buyers,  it  is  assumed  that  con- 
sideration is  given  to  book  values. 

When  no-par  value  stock  is  purchased  at  more  than  original 
issue  price,  surplus  is  in  fact  depleted  and  surplus  account  should 
be  debited.  As  the  capital  is  being  reduced,  it  is  proper  to  debit 
capital  surplus  with  the  excess. 

Unissued  Capital  Stock 

This  should  be  distinguished  from  treasury  stock.  Good 
accounting  practice  does  not  require  any  entry  therefor  in  the 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  209 

books  of  account  until  it  has  been  subscribed  for.  There  is  no 
objection  to  making  a  statement  regarding  the  authorized  and 
unissued  stock  in  a  balance  sheet,  but  it  should  appear  under  the 
caption  'Xapital  Stock"  and  not  on  the  asset  side  of  the  balance 
sheet. 

WASTING  ASSETS 

Certain  assets,  such  as  mines,  lumber,  etc.,  are  in  a  sense  both 
current  and  fixed  in  their  nature,  but  almost  invariably  a  consider- 
able degree  of  permanence  attaches  to  them,  and,  since  their 
conversion  into  cash  is  a  very  gradual  process,  such  assets  should 
appear  as  a  subdivision  of  those  which  are  known  as  ''fixed.  "^ 

Values  to  be  Written  Down 

It  is  obvious  that  a  mine  or  a  tract  of  timber  from  which  ore  is 
being  taken  or  timber  removed  is  worth  less  at  the  end  of  a  fiscal 
period  than  at  its  commencement.  Consequently  the  balance 
sheet  valuation  should  be  reduced  in  direct  proportion  to  the 
depletion  of  the  mine  or  the  cutting  of  the  timber. 

There  is,  however,  a  decided  difference  between  the  necessity 
for  providing  for  the  renewal  of  plant  and  making  good  the 
diminishing  value  of  a  mine.  In  one  case  it  must  not,  and  cannot, 
be  assumed  that  there  will  be  no  new  machinery  to  buy,  whereas 
the  owners  of  a  mine  expect  that  the  product  thereof  will  be  con- 
verted into  cash  and  become  available  for  distribution  as  divi- 
dends, unless  they  decide  to  retain  the  proceeds  and  invest  them 
in  other  ways. 

In  such  cases  the  law  does  not  prevent  payment  of  dividends 
out  of  capital,  but  the  by-laws  of  the  board  of  directors  of  a  cor- 


3  The  valuation  and  depletion  of  wasting  assets  has  required  special  atten- 
tion in  tax  matters.  Those  desiring  detailed  information  regarding  the  valua- 
tion and  depletion  of  mines,  oil  wells,  timber,  and  other  natural  resources,  will 
find  an  exhaustive  treatment  in  Income  Tax  Procedure,  192 1,  page  923  et  seq. 
Also  see  Volume  II  of  this  book  for  special  points  in  the  audits  of  these  enter- 
prises. 

Also  see  The  Taxation  of  Income  from  Natural  Resources,  by  R.  V.  Norris, 
in  The  Federal  Income  Tax,  Columbia  University  Lectures,  1921. 

VOL. I — ^4 


2IO  AUDITING— GENERAL  PRINCIPLES 

poration  may  prohibit  it.  The  auditor  must  acquaint  himself 
with  the  facts  of  each  case. 

The  usual  method  of  calculating  depletion  is  to  take  the  pur- 
chase price  or  appraised  value  and  divide  it  by  the  estimated 
number  of  units  of  quantity  to  be  extracted.  This  calculation 
gives  the  estimated  cost  or  value  of  each  unit.  The  quantity 
extracted  in  any  stated  period  is  multiplied  by  the  amount  as- 
cribed to  each  unit,  resulting  in  the  total  depletion  allowance  for 
the  period.  From  the  standpoint  of  a  simple  arithmetical  calcu- 
lation, the  method  has  much  to  commend  it.  It  should  not 
appeal  to  those  who  put  conservatism  and  expediency  above 
accurate  accounting;  since  the  exact  quantity,  the  time,  and  costs 
of  extraction  are  all  estimated,  conservatism  and  expediency  are 
not  served  by  using  the  same  rate  for  each  unit  extracted  during 
the  first  year  as  during  the  twentieth  or  fortieth;  conservatism 
(not  accuracy)  calls  for  heavier  allowances  during  the  early  years 
than  during  the  uncertain  later  years.  It  does  not  appeal  to 
those  who  contend  that  under  a  correct  method  of  computation 
the  net  charges  are  less  during  the  early  years  than  during  the 
later  years.  Many  wasting  assets  are  purchased  on  careful  esti- 
mates of  quantities,  life,  and  values;  the  gross  figures  are  reduced 
to  present  worth;  the  calculations  are  available  so  that  accurate 
accounting  should  reflect  the  details  of  the  transaction  rather  than 
to  take  the  average.  The  average  method  is  erroneous  because  it 
ignores  conservatism,  which  calls  for  heavier  allowances  during  the 
early  years.  It  ignores  the  actual  basis  of  the  transaction  which 
reflects  the  constantly  reducing  cost  of  carrying  the  investment. 
Interest  is  an  actual  factor  in  arriving  at  present  worth,  and  under 
accurate  accounting  the  gross  purchase  price  would  be  set  up  and 
depleted,  and  the  discount  would  be  set  up  and  amortized. 

When  a  fiat  purchase  price  paid  as  a  result  of  bargaining,  or 
an  appraisal,  is  not  based  on  definite  gross  figures  reduced  to  pres- 
ent worth,  the  rough  and  ready  average  basis  is  about  as  satis- 
factory as  any  other,  provided  the  total  quantity  and  the  Hfe  are 
understated  as  much  as  good  practice  permits. 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  211 

This  rough  and  ready  method,  however,  does  not  produce  the 
rate  of  return  on  investment  which  is  expected.  When  a  coal 
mine  costs  $100,000  and  is  estimated  to  contain  1,000,000  tons  of 
coal,  under  the  usual  method  of  depletion  10  cents  a  ton  is  set 
aside  or  reserved  for  each  ton  mined.  If  100,000  tons  are  mined 
each  year  the  annual  depletion  allowance  is  $10,000.  If  the  net 
profit  is  20  cents  a  ton  after  the  depletion  charge  and  excluding 
income  from  the  investment  of  the  fund  representing  the  reserve, 
the  profit  per  annum  is  $20,000,  or  20  per  cent  on  the  original 
investment.  If  all  of  the  profits  are  distributed  and  if  the  depletion 
reserve  is  invested  at  5  per  cent  per  annum,  the  additional  net 
income  is  $500  the  second  year,  $1,025  the  third  year  and  an  in- 
creasing amount  thereafter.  If  both  the  net  profits  and  the  de- 
pletion reserve  are  distributed,  there  is  an  increasing  rate  of  return 
each  year  because  of  the  decreasing  net  investment.  During  the 
tenth  year  the  investment  is  $10,000  and  the  net  income  is  $20,000 
or  200  per  cent  on  the  investment,  as  against  20  per  cent  the  first 
year. 

This  illustration  proves  that  the  usual  method  is  inaccurate, 
unscientific;  nor  does  it  reflect  the  intention  of  the  investor. 
When  the  original  investment  was  made  it  was  expected  that 
under  continuing  relative  costs  of  mining  and  sales  prices  the 
annual  rate  of  return  would  be  the  same.  Instead  of  the  depletion 
reserve  being  the  same  each  year,  there  should  be  taken  into 
consideration  either  the  decreasing  investment,  or  the  income 
from  the  investment  of  the  depletion  reserve.  On  a  5  per  cent 
basis  the  depletion  allowance  is  $7,950.46  per  annum  instead  of 
$10,000.  Adding  the  annual  income  from  the  investment  of  the 
fund  representing  the  reserve  to  the  operating  profit,  the  owner 
will  realize  the  same  total  profit  each  year. 

When  a  purchase  is  made  on  the  basis  of  the  present  worth 
of  agreed-upon  future  extraction,  it  would  seem  that  the  proper 
periodical  entries  thereafter  are  merely  reversals  of  the  detailed 
items  used  in  the  original  computation;  the  procedure  proposed, 
however,  is  not  in  use. 


212  AUDITING— GENERAL  PRINCIPLES 

1.  Mines. — The  auditor  should  follow  the  suggestions  relating 
to  land  ( page  1 8 1)  so  far  as  title  and  encumbrances  are  concerned. 

In  verifying  the  accuracy  of  the  value  placed  upon  mining 
property  the  auditor  as  a  rule  does  not  have  much  to  guide  him. 
He  must,  however,  keep  in  mind  the  fact  that  as  operations  pro- 
ceed value  decreases  unless  development  and  exploration  work 
disclose  new  values.  An  analysis  of  the  original  cost,  taken  into 
consideration  along  with  the  engineer's  estimates  of  total  contents, 
is  a  valuable  check  on  the  allowance  for  depletion.  It  may  not  be 
customary  to  submit  the  engineer's  records  to  the  auditor,  but  the 
latter  is  on  notice  that  no  well-managed  mining  company  at- 
tempts operation  on  a  large  scale  unless  fortified  by  the  scientific 
calculations  of  skilled  engineers.  In  recent  years  many  valua- 
tions have  been  made  for  federal  tax  purposes.  With  these  before 
him  and  with  the  records  of  production  as  shown  by  the  books,  an 
auditor  can  arrive  at  a  reasonable  conclusion  as  to  how  the  book 
valuations  have  been  estimated.  If  his  own  figures  vary  much 
from  the  books',  the  auditor  should  investigate  further. 

2.  Timber  Land. — It  is  assumed  that  all  timber  propositions 
which  have  arrived  at  a  stage  where  an  audit  is  in  order  are  con- 
ducted on  a  well-thought-out  plan.  The  quantity  of  standing 
timber  will  have  been  estimated  and  verified  (cruised)  and,  with 
this  as  a  starting  point,  the  auditor  can  estimate  the  average  de- 
pletion charge  to  be  made. 

Obviously  any  attempt  to  certify  to  results  based  on  an  ex- 
amination of  money  values  is  extremely  hazardous.  The  books 
should  show  quantities  as  well.  If  they  do  not,  the  auditor  should 
regard  them  with  suspicion. 

3.  Oil  Wells. — The  rules  for  determining  values  of  other 
wasting  assets  are  not  apphcable  to  oil  wells.  The  original  or 
"  flush  "  flow  is  no  criterion  of  the  settled  flow  except  in  a  few  fields. 
In  no  case  is  the  Hfe  of  a  producing  oil  well  known.  The  auditor 
who  examines  the  accounts  of  an  oil  company  for  the  first  time 
should  study  some  of  the  exhaustive  special  information  which  is 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  213 

available.  Nearly  all  of  the  leading  companies  issue  annual 
reports  containing  details  of  operations  and  valuations.  With 
these  as  a  guide  no  more  difficulty  will  be  encountered  than  with 
other  audits. 

CONTINGENT  ASSETS 

Contingent  assets  are  those  which  have  not  been  reduced  to 
definite  money  values;  if  shown  on  a  balance  sheet  they  are  not 
included  in  the  aggregate  valuation  of  the  assets.  In  nearly  all 
active  business  concerns  claims  exist  which  are  in  dispute.  Taxes 
may  be  overpaid,  damages  may  be  claimed  for  infringement  of 
patents  or  for  failure  to  fulfil  the  terms  of  contracts.  A  general 
inquiry  will  usually  develop  items  of  this  nature.  When  impor- 
tant enough,  mention  thereof  should  be  made  on  balance  sheets. 

The  auditor  rarely  discovers  any  trace  of  assets  the  accounts 
of  which  have  been  omitted  from  the  books,  but  occasionally  he  is 
fortimate  enough  to  disclose  tangible  assets  which,  if  properly 
applied,  increase  the  net  worth  of  the  business  under  audit;  for 
instance,  doubtful  accounts  written  off;  securities  deemed  worth- 
less; and  judgments  not  finally  awarded,  which  may  become 
valuable.  The  author  knows  of  one  instance  in  which  a  company 
secured  a  judgment  for  $33,000  for  damages  against  another 
solvent  company.  The  item  did  not  appear  as  an  asset  upon  the 
books.  Two  appeals  were  taken  and  won,  and  after  a  final  favor- 
able decision  the  claim  was  paid  with  interest  and  costs.  The 
company's  capital  stock  is  $10,000,  so  that  the  collection  of  the 
judgment  materially  changed  its  financial  position. 

Capital  Stock  Calls  and  Assessments 

In  some  states  a  statutory  liability  exists  on  the  part  of  stock- 
holders in  business  corporations  for  an  amount  additional  and 
equal  to  the  par  value  of  the  shares.  This  corresponds  to  the 
liability  of  stockholders  in  all  national  banks  and  in  some  state 
banks  and  trust  companies.  If  the  possibility  of  such  recovery 
exists,  it  is  an  asset  which  should  be  taken  into  consideration. 


214  AUDITING— GENERAL  PRINCIPLES 

The  credit  of  a  company  incorporated  in  a  state  having  such  a 
law  should  be  strengthened  thereby,  particularly  if  some  or  all  of 
its  stockholders  are  of  recognized  financial  standing.  It  is  not  cus- 
tomary to  show  the  statutory  habihty  on  balance  sheets  although 
it  is  useful  information.  The  auditor  should  acquaint  himself  with 
the  facts  and  consider  the  advisability  of  mentioning  it. 

In  other  cases  the  auditor  may  find  that  the  capital  stock  has 
been  only  partly  paid  and  that  the  uncalled  instalments  are 
neither  charged  to  the  stockholders  in  the  books,  nor  mentioned 
in  the  statements.  This  occurs  if  the  corporation  is  a  close  one  in 
which  officers  and  directors  are  identical.  The  amount  callable 
should  be  ascertained  and  the  probabiHty  of  collection  should  be 
duly  considered. 

Liabilities  of  Directors 

In  many  states  directors  are  personally  responsible  for  debts 
contracted  under  certain  circumstances  or  in  excess  of  certain 
sums.  If  there  is  any  possibility  of  such  contingencies,  the  audi- 
tor should  refresh  his  memory  as  to  the  laws  governing  corpora- 
tions of  the  state  in  which  the  company  is  incorporated,  or  in 
which  it  has  its  principal  office,  and  ascertain  whether  or  not  the 
directors  have  automatically  made  themselves  responsible  for  any 
part  of  the  indebtedness.  This  is  especially  important  if  an 
examination  is  being  made  for  creditors. 

SECRET  RESERVES 

After  all  recorded  assets  have  been  considered,  and  after  due 
attention  has  been  given  to  any  assets  which  have  been  inad- 
vertently or  fraudulently  omitted  from  the  records,  it  may  be 
necessary  to  determine  why  assets  have  been  intentionally  omitted 
from  the  books  or  the  balance  sheet,  or  both.  These  are  exclusive 
of  "contingent"  assets  which  are  discussed  on  page  213.  Assets 
may  exist  and  may  be  known  to  everyone  connected  with  an 
enterprise,  but  instructions  from  an  executive  source  may  result 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  215 

in  the  entire  omission  of  such  assets  from  the  published  reports  of 
the  concern's  financial  standing,  and  the  assets  may  not  appear 
on  the  books  of  account.  Or  there  may  be  obvious  undervalua- 
tions which,  after  being  so  carried  for  a  number  of  years,  are 
suddenly  written  up  to  their  actual  value. 

How  Secret  Reserves  Are  Created 

As  a  matter  of  fact,  the  auditor  does  not  find  a  great  many 
instances  of  secret  reserves,  but,  if  he  represents  stockholders  or 
others  who  are  interested  in  knowing  the  full  value  of  the  assets, 
he  should  consider  the  possibiHty  of  the  following  improper  treat- 
ment of  accounts  or  assets  : 

1.  Systematic  concealment  of  additions  to  plant  or  equipment 
through  charging  the  cost  thereof  to  maintenance  instead  of  to  asset 
accounts. 

This  practice  must  be  clearly  proven,  because  it  is  not  in- 
tended to  condemn  unreservedly  the  occasional  charging  off  of 
plant  additions  if  the  obvious  purpose  is  to  be  conservative,  and 
if  cost  is  not  a  material  factor  in  the  operations  of  the  period. 
But  if  it  is  evident  that  a  considerable  sum  has  been  expended  on 
improvements  and  if  there  is  no  reflection  thereof  in  the  accounts, 
the  auditor  should  insist  on  restating  the  accounts  and  should 
bring  out  clearly  the  actual  earnings  of  the  period  even  though  a 
special  reserve  is  set  up  for  the  amount  not  previously  capitalized. 

2.  The  creation  of  excessive  reserves  for  depreciation,  had  debts, 
or  similar  items,  unless  the  fact  that  the  reserves  are  excessive  is  ex- 
pressed on  the  face  of  the  balance  sheet. 

This  is,  perhaps,  the  favorite  method  of  deceiving  minority 
stockholders  when  the  directors  or  other  insiders  wish  tempo- 
rarily to  understate  the  earnings  as  well  as  the  assets. 

It  is  not  intended  to  condemn  at  this  point  the  practice  of 
setting  aside  what  may  appear  to  be  excessive  reserves  to  provide 
for  probable  losses.  In  such  cases,  if  the  reserves  are  officially 
created,  the  auditor  can  hardly  object  to  the  presentation  of  the 
accounts  as  they  appear  on  the  books. 


2l6  AUDITING— GENERAL  PRINCIPLES 

The  auditor  is  so  accustomed  to  these  reserves  being  insuffi- 
cient that  he  feels  reluctant  to  criticize  liberal  allowances,  unless 
there  is  an  apparent  desire  to  defraud  innocent  stockholders. 
Otherwise,  he  commends  the  disposition  to  be  conservative,  and 
watches  with  interest  the  final  outcome  of  the  reserves. 

3.  Inventories  should  reflect  fair  values  {as  explained  in  Chapters 
VIII  and  IX),  but  there  is  a  limit  beyond  which  valuations  cannot 
be  reduced,  unless  the  circumstances  of  the  reduction  are  stated  on  the 
face  of  the  balance  sheet. 

This  rule  is  of  somewhat  greater  importance  than  the  preced- 
ing one,  because  reserves  stand  out  to  a  certain  extent  and  grossly 
excessive  reserves  are  apparent;  but  if  an  inventory  is  under- 
valued, anyone  unacquainted  with  the  fact  is  not  able  to  detect 
the  fraud,  no  matter  how  carefully  the  balance  sheet  is  analyzed. 
If  there  is  an  honest  desire  to  be  ultra-conservative  and  to  write 
something  off  the  inventory  after  it  has  been  properly  valued,  it 
should  be  accompHshed  by  creating  a  ^'reserve  for  possible  loss  on 
realization  of  inventory"  and  setting  up  this  reserve  on  the 
balance  sheet,  with  a  footnote  stating  that  the  inventory  itself  is 
not  excessive. 

If  those  responsible  for  balance  sheet  valuations  wish  to  write 
down  the  inventory,  but  do  not  wish  the  fact  to  be  reflected  in  the 
balance  sheet,  the  auditor  is  put  on  notice  that  an  attempt  is 
being  made  to  deceive  someone.  The  lack  of  a  good  reason  for 
concealing  the  truth  is  prima  facie  evidence  of  dishonesty  and  the 
auditor  should  act  accordingly. 

4.  The  circumstances  surrounding  the  writing  down  of  assets 
must  be  carefully  looked  into. 

So  many  assets  are  overvalued  that  it  is  usually  refreshing 
when  an  auditor  discovers  a  willingness  to  write  down  overvalua- 
tions out  of  profits.  Instances  are  known,  however,  where  such 
adjustments  have  been  so  stated  as  to  conceal  their  true  import 
and  minority  stockholders  have  lost  thereby. 

In  all  cases  the  full  earnings  of  a  period  should  be  shown,  and 
if  it  is  desirable  to  write  off  assets,  such  as  good- will,  or  to  write 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  217 

down  overvaluations,  such  items  must  appear  as  extraordinary- 
deductions  and  not  as  applicable  solely  to  the  period  under  re- 
view. If  the  accounts  are  so  stated,  no  fault  can  be  found  with 
them.  A  stockholder  who  does  not  understand  accoimts  may  look 
at  the  final  figures  and  form  an  erroneous  conclusion  as  to  the 
actual  profit  of  the  period,  but,  if  there  is  no  attempt  to  deceive 
and  if  the  accounts  are  clearly  set  forth,  the  stockholder  is  simply 
suffering  the  penalty  of  his  ignorance. 

Reasons  for  Undervaluations. — There  does  not  appear  to 
be,  from  an  accounting  standpoint,  any  justification  for  flagrant 
undervaluations  under  any  circumstances;  but  since  the  practice 
has  supporters  among  some  very  reputable  financiers,  it  is  at 
least  in  order  to  examine  the  arguments  used  in  support  of  secret 
reserves.  The  principal  argument  is  that  stockholders  are  notori- 
ously hungry  for  dividends,  and  that  a  surplus  available  (in 
their  opinion)  for  dividends,  but  not  so  distributed,  reflects  no  credit 
whatever  on  the  management,  but  quite  the  contrary.  On  the 
other  hand,  if  the  profits  of  the  good  years  are  all  divided  so  that 
when  the  inevitable  poor  year  arrives  the  dividend  must  be  passed, 
there  is  bitter  criticism.  Some  boards  of  directors  think  that 
stockholders  as  a  class  must  not  have  full  information,  for  their 
own  good;  therefore,  in  order  to  avoid  criticism,  the  profits  of  the 
good  years  are  not  fully  disclosed  and  dividends  are  continued 
through  the  unprofitable  periods. 

Banks  and  trust  companies  assume  this  patriarchal  attitude 
more  frequently  than  do  industrial  corporations.  Perhaps  there 
is  some  justification  for  this  practice  on  the  part  of  banks  whose 
stockholders  are  rarely  changed  and  whose  dividends  are  largely 
depended  upon  for  living  expenses. 

With  respect  to  the  banking  house  and  equipment,  there  can 
be  little  if  any  objection  to  writing  down  their  value  to  a  nominal 
amount.  Except  in  a  few  localities,  bank  buildings  and  bank 
furniture  are  not  assets  which  can  be  realized  upon  to  pay  de- 
positors.   The  building  occupied  by  a  failed  bank  is  not  an  attrac- 


2l8  AUDITING— GENERAL  PRINCIPLES 

tive  place  for  another  bank  to  start  business  in,  and  it  is  rarely 
suitable  for  anything  else.  It  may  be  proper,  therefore,  for  a  bank 
to  write  down  its  property  account  to  the  actual  value  of  the  land 
and  the  auction  value  of  its  furniture,  vaults,  etc.  This  is  a  secret 
reserve  on  the  basis  of  a  going  business;  but  since  banks  publish 
frequent  statements  of  their  assets,  no  one  who  owns  stock  and 
who  desires  to  ascertain  the  book  value  of  the  stock  need  be  de- 
ceived. 

Of  course,  if  a  bank's  premises  are  also  occupied  by  tenants 
who  pay  remunerative  rentals,  this  fact  should  be  taken  into  con- 
sideration in  writing  down  the  book  valuations.  It  might  be  fair 
to  assume  that,  if  a  sudden  demand  for  funds  were  made  and  it 
became  necessary  to  sell  the  building,  a  price  could  be  imme- 
diately realized  which  would  represent  the  capitalized  valuation 
of  the  property,  assuming  that  the  bank's  own  quarters  would  not 
yield  any  return. 

Limitations  on  Undervaluations. — There  are  few,  if  any, 
other  classes  of  enterprises  where  there  is  any  justification  for 
writing  down  the  cost  or  value  of  assets  in  order  to  provide  a  secret 
reserve  to  be  held  in  abeyance  to  pay  dividends  on  a  constant 
basis.  The  stockholders  of  industrial  corporations  do  not  have  as 
good  an  opportunity  of  forming  an  opinion  upon  published  bal- 
ance sheets  as  do  the  stockholders  of  banks.  They  must  rely  on 
the  accuracy  of  the  amount  which  is  reported  as  the  net  income 
for  the  period.  Such  stock  changes  hands  more  frequently  than 
bank  stock. 

It  is  apparent  that  a  stockholder  who  desires  to  sell  and  who 
fixes  a  price  upon  his  stock  based  upon  the  reported  earnings  of 
the  last  period  is  at  a  great  disadvantage  as  compared  with  a 
prospective  purchaser  of  his  stock  who  knows  that  the  full  earn- 
ings were  not  disclosed  by  the  report,  and  that  a  part  of  the  profit 
was  diverted  to  a  secret  fund  which  it  was  proposed  to  use  sub- 
sequently to  bolster  up  an  unusually  unprofitable  period. 

It  has  been  argued  that  good  faith  on  the  part  of  the  manage- 


BALANCE  SHEET  AUDIT— FIXED  ASSETS  219 

ment  should  be  the  sole  test  of  whether  or  not  such  transactions 
are  acceptable  enough  to  a  professional  auditor  to  warrant  his 
certifying  to  a  balance  sheet  and  income  account  in  which  they 
appear. 

The  Auditor's  Position. — ^An  auditor  can  give  advice,  but 
he  cannot  control  the  action  of  a  board  of  directors,  nor  in  this 
country  does  he  often  communicate  directly  with  the  stockholders 
of  a  corporation.  What  should  he  do  when  he  is  asked  to  certify 
to  a  statement  which  he  believes  contains  all  of  the  facts  and 
figures  which  the  board  of  directors,  acting  for  the  stockholders 
and  for  their  interests,  think  they  should  have,  but  which  conveys 
a  false  impression  because  the  profits  are  understated  owing  to 
the  creation  of  a  secret  reserve? 

The  auditor  who  finds  himself  in  such  an  uncomfortable  situa- 
tion has  but  one  course  to  pursue;  he  should  send  in  his  report 
setting  out  the  true  facts  as  he  has  found  them,  and  commenting 
upon  the  asset  valuations  of  which  he  cannot  approve.  The 
directors  cannot  publish  the  report  unless  the  existence  of  the 
secret  reserve  is  disclosed.  If  they  do  not  publish  the  auditor's 
report,  but  put  out  an  uncertified  balance  sheet,  the  auditor  can 
do  nothing. 

It  might  not  be  a  bad  idea  to  urge  every  stockholder  proposing 
to  sell  his  stock  to  call  for  a  professional  auditor's  report  upon  the 
accounts  and  affairs  of  the  corporation  before  the  sale  is  consum- 
mated; but,  unfortunately  for  professional  auditors,  the  value  of 
their  certificates  is  not  yet  appreciated  by  the* majority  of  in- 
vestors. When  a  man  buys  a  horse  he  wants  it  examined  by  an 
expert  on  horses;  so  he  calls  in  a  veterinarian.  The  man  knows 
less  about  accounts  and  values  than  about  horses,  but  he  does  not 
think  of  calling  in  an  expert  on  values  or  accounts  when  he  buys 
or  sells  a  share  of  stock.  He  has  heard  about  the  value  of  the  ser- 
vices of  a  veterinarian  since  his  childhood,  but  he  does  not  know 
that  the  absence  of  an  auditor's  certificate  from  a  balance  sheet 
may  indicate  that  the  assets  shown  therein  are  improperly  stated, 


220  AUDITING— GENERAL  PRINCIPLES 

and  that  if  he  decides  to  sell  because  the  business  does  not  appear 
to  be  as  prosperous  as  he  thought  it  would  be,  his  action  is  exactly 
in  line  with  the  intention  of  the  insiders,  who  promptly  buy  out 
all  those  who  have  become  discouraged. 

The  fact  of  the  matter  is  that  an  auditor  is  taking  big  chances 
when  he  passes  a  balance  sheet  which  conceals  or  understates 
assets.  Good  faith  may  be  only  apparent,  the  real  purpose  of  the 
management  being  to  buy  the  interests  of  the  misinformed. 

In  no  event,  however,  should  an  auditor  certify  to  a  balance 
sheet  from  which  any  asset  has  been  omitted  entirely.  The  argu- 
ments in  favor  of  an  undervaluation  are  weak  enough,  supported 
as  they  are  by  the  general  assertion  that  the  item  speaks  for  itself 
in  the  balance  sheet;  but  there  can  be  no  argument  at  all  to  sup- 
port the  complete  omission  from  the  asset  side  of  the  balance 
sheet  of  any  item  of  property,  tangible  or  intangible,  which  has  or 
may  have  a  market  value. 

The  auditor  who  knowingly  certifies  to  such  a  statement  can 
be  held  responsible,  and  money  damages  can  be  recovered  from 
him  by  any  stockholder  parting  with  his  stock  on  the  basis  of  the 
balance  sheet  figures.  Such  an  action  can  be  founded  on  a  charge 
of  deceit  or  fraud  depending  upon  the  circumstances  of  each  case. 


CHAPTER  XII 

BALANCE   SHEET  AUDIT— LIABILITIES 

In  a  balance  sheet  audit  nothing  is  more  important  than 
to  ascertain  whether  or  not  all  the  liabilities  appear  and  are 
properly  stated. 

At  the  outset  of  this  chapter  it  may  be  proper  to  illustrate 
this  point  in  order  that  the  auditor  may  realize  the  importance 
of  placing  himself  in  the  position  of  the  one  who  reads  the  balance 
sheet  later. 

Information  Bankers  Require 

Bankers  extend  credit  to  trading  concerns,  not  to  furnish 
additional  capital,  but  to  assist  them  to  carry  stock-in-trade, 
or  accounts  receivable,  at  their  busy  season;  and  they  expect 
to  have  the  borrowings  repaid  or  materially  reduced  during 
the  dull  season.  Therefore  the  balance  sheet  of  a  trading 
concern  is  always  scanned  closely  by  the  banker  to  determine 
the  proportion  of  current  assets  to  current  liabilities,  and  he 
calculates  the  time  within  which  the  stock-in-trade  should  be 
realized  upon.  It  may  be  that  the  concern  has  contracted  to 
purchase  large  quantities  of  goods  which  have  not  been  received 
and  these  contracts  may  call  for  large  cash  payments  within  a 
comparatively  short  time.  Furthermore,  the  contracts  may 
have  been  made  on  a  declining  market,  and  the  goods  to  arrive 
may  cost  more  than  would  have  been  the  case  if  not  contracted  for 
in  advance.  This  information  does  not  appear  on  the  regular 
books  of  account,  but  is  it  not  the  kind  of  information  which  the 
banker  requires  to  enable  him  to  make  up  his  mind  in  passing 
upon  the  desirability  of  the  risk,  and  is  it  not  the  kind  of  infor- 
mation which  an  auditor  should  seek  in  order  to  be  of  substantial 
value  to  his  client? 

221 


222  AUDITING— GENERAL  PRINCIPLES 

Position  of  Auditor 

The  auditor  who  limits  himself  to  an  examination  of  the  for- 
mal books  of  account  in  making  an  audit  is  preventing  himself,  in 
many  cases,  from  being  of  constructive  value,  and  in  other  cases 
he  is  approaching  the  limits  of  liability  in  money  damages  for 
negligence  in  not  doing  all  that  a  skilful  and  experienced  auditor 
should  do.  It  is  conceded  that  when  an  auditor  assumes  to  pass 
on  matters  which  are  not  in  the  books  he  is  opening  up  a  wide 
field,  perhaps  a  troublesome  one  to  cover;  but  it  may  as  well  be 
admitted  that  the  ordinary  so-called  checking  of  books,  and  the 
subsequent  balance  sheet  prepared  therefrom,  are  about  as 
valuable  to  the  banker  or  other  creditor  as  the  information  which 
the  borrower  can  and  does  furnish  himself. 

Determination  of  Liabilities 

In  the  audit  of  assets  the  element  of  opinion  is  an  important 
one.  Values  depend  on  estimates;  estimates  are  based  on 
opinions  and  the  exercise  of  judgment.  In  the  audit  of  liabilities 
the  element  of  opinion  is  negligible  because  most  liabilities  are 
fixed  and  definite  in  amount.^  There  may,  of  course,  be  con- 
tingent liabilities,  such  as  unfavorable  open  contracts  and  law- 
suits, but  these  items  are  usually  susceptible  of  verification.  The 
chief  difficulty  regarding  liabilities  lies  in  their  ascertainment; 
there  is  no  such  difficulty  in  determining  the  exact  amount  of  a 
liability  as  there  is  in  the  case  of  any  assets  other  than  cash.  An 
account  receivable  believed  to  be  good  is  frequently  bad;  the 
entire  aggregate  of  accounts  payable  (in  a  going  business)  must 
be  paid  in  full. 

The  items  on  the  liability  side  of  the  balance  sheet  which 
must  be  determined  are  few  in  number.  Some  hold  that  the 
term  ^' value"  or  "inventory"  is  not  properly  apphcable  to  lia- 


^  "The  accounting  problems  having  to  do  with  Habihties  are  extremely- 
simple  as  compared  with  those  relating  to  assets.  This  is  principally  due  to  the 
fact  that  the  question  of  valuation,  so  perplexing  in  regard  to  assets,  practically 
disappears  when  liabihties  are  concerned."  (Henry  R.  Hatfield,  Modern  Ac- 
counting, page  185.) 


BALANCE  SHEET  AUDIT— LIABILITIES  223 

bilities;''  others  hold  that  the  word  ''inventory"  maybe  applied 
to  liabilities.  ^  Irrespective  of  terminology,  all  liabilities  which 
can  be  determined  should  appear  in  the  balance  sheet. 

Distinction  Between  Liabilities  and  Capital 

Exclusive  of  reserves  there  are  three  classes  of  items  on  the 
credit  or  right-hand  side  of  the  balance  sheet,  viz.,  (i)  liabilities, 
(2)  capital,  and  (3)  items  which  are  liabilities  or  capital,  depend- 
ing on  circumstances. 

The  effect  which  the  application  of  certain  items  may  have  on 
the  financial  statement  of  a  concern  and  its  virtual  solvency  or 
insolvency  in  relation  to  general  creditors,  is  indicated  by  the 
illustrations  stated  below. 

In  some  cases  credit  balances  may  appear  in  the  statement  as 
capital  when  they  are  actually  liabilities.  In  other  instances 
such  balances  may  appear  as  liabilities  when  by  reason  of  having 
been  subordinated  or  for  other  causes  they  are  really  capital. 

It  seems  almost  incredible  that  such  should  be  the  case  but  it 
is  true.    In  one  case  a  corporation  on  its  books  annually  credited 

2  "To  the  liability  items  of  the  balance  sheet,  principles  of  valuation  are 
not  directly  appHcable  as  such,  except  so  far  as  content  or  inclusion  and  meas- 
ure of  quantity  or  aniount  may  be  said  to  embody  considerations  of  valua- 
tion. "     (R.  B.  Kester,  Accounting — Theory  and  Practice,  Vol.  II,  page  97.) 

"The  principle  of  showing  the  full  truth  as  to  the  liabilities  raises  the 
problem  of  the  complete  inclusion  or  inventory  of  the  liabilities.  Under  this 
will  be  considered  any  adjustments  that  must  be  made  in  the  book  record  in 
order  to  show  the  true  state  of  the  liabilities,  and  also  the  proper  treatment  of 
contingent  Habilities  so  as  to  show  their  relation  to  the  state  of  the  business." 
(Ibid.,  page  342.) 

3  "In  addition  to  the  asset  inventories  discussed  in  the  foregoing  section, 
there  are  also  liability  inventories.  The  purpose  of  such  inventories  is  also  to 
equalize  charges  over  two  or  more  accounting  periods.  For  example,  at  the 
end  of  a  given  accounting  period  it  may  be  noted  that  a  certain  portion  of  the 
year's  taxes  have  accrued  but  have  not  yet  been  paid.  Suppose  experience 
shows  that  the  year's  taxes  will  be  $120,  payable  at  the  end  of  the  tax  year. 
The  period  for  which  the  tax  will  be  assessed  may  not  coincide  with  the 
concern's  accounting  period;  wherefore,  part  of  the  $120  is  chargeable  to  one 
accounting  period  and  the  balance  to  the  next.  .  .  . 

".  .  .  .  If  such  asset  and  liability  inventory  adjustments  are  not  made 
at  the  end  of  an  accounting  period,  it  is  clear  that  the  accidental  circumstances 
of  payment  or  non-payment  of  cash  will  affect  the  profits  of  the  period  either 
favorably  or  unfavorably.  Either  is  undesirable,  since  a  distorted  and  untrue 
picture  of  affairs  of  the  business  is  thus  given."  (Stephen  Oilman,  Principles 
of  Accounting,  pages  49,  50.) 


224  AUDITING— GENERAL  PRINCIPLES 

all  of  its  earnings  to  the  personal  accounts  of  its  stockholders; 
the  latter  dealt  with  the  book  credits  as  dividends  received,  and 
paid  income  taxes  thereon.  In  all  published  balance  sheets 
and  in  statements  to  mercantile  agencies  the  stockholders'  credit 
balances  were  shown  as  surplus — not  as  liabilities.  The  capital 
stock  was  $10,000;  the  so-called  surplus  was  $800,000.  It  was 
held  that  the  stockholders  did  not  rank  as  creditors.  In  many 
cases  debts  due  to  stockholders  are  specifically  subordinated  to 
the  claims  of  all  creditors  past,  present,  and  future.  In  other 
cases  securities  are  issued  which  on  their  face  are  debts  but  which 
are  so  restricted  in  their  remedies  that  they  should  be  classed  as 
capital.  Assessments  paid  by  stockholders,  carried  on  the  cor- 
poration's books  as  loans,  will  be  held  to  be  capital  if  the  facts 
disprove  the  entries  on  the  books.  ^  In  the  case  of  an  issue  of  so- 
called  debenture  bonds,  the  maturity  date  is  1990;  interest  is 
payable  only  when  declared  by  the  directors  and  is  not  cumu- 
lative; by  express  language  no  claim  can  be  made  for  principal  or 
interest  at  any  time  when  there  is  any  obligation,  direct  or 
contingent,  to  others.  The  holders  of  the  ''bonds"  are  creditors 
only  so  far  as  the  stockholders  are  concerned.  The  full  amount 
shown  to  be  due  to  the  ''bond"  holders  is  at  the  risk  of  the 
business  and  ranks  as  capital  so  far  as  creditors  and  prospective 
creditors  are  concerned.  These  conditions  illustrate  the  third 
class  mentioned  above. 

Subordinated  Debts. — The  purpose  of  the  subordination  of 
obligations  is  to  protect  creditors  and  to  improve  the  financial 
showing  of  the  concern  affected.  Auditors  are  competent  to 
pass  upon  the  general  features  of  subordination  agreements, 
but  when  there  is  any  doubt,  and  when  such  questions  as  publi- 
cation and  recording  arise,  the  opinion  of  lawyers  should  be 
secured.  When  the  fact  of  subordination  is  established,  full 
effect  must  be  given  thereto  in  the  balance  sheet,  otherwise 


4  For  numerous  rulings  on  specific  cases  in  which  the  distinction  between 
capital  and  liabilities  is  fully  discussed  and  passed  upon  by  the  Treasury,  see 
Excess  Profits  Tax  Procedure,  192 1. 


BALANCE  SHEET  AUDIT— LIABILITIES  225 

most  and  sometimes  all  of  the  intended  effect  will  be  lost.  The 
inclusion  of  subordinated  items  in  accounts  payable,  even  though 
an  explanatory  note  appears,  is  not  the  proper  form  of  statement; 
subordinated  claims  or  debts  should  be  separately  stated  immedi- 
ately preceding  capital  items.  In  the  case  of  general  partnerships 
there  can  be  no  liability  to  any  partner.  So-called  loans  from 
the  partners  are  not  debts;  for  the  purpose  of  interpartnership 
accounting  they  may  be  so  treated  in  the  books  of  account,  but  in 
published  balance  sheets  all  of  the  partners'  accounts,  debit  and 
credit,  should  be  merged  in  one,  and  set  up  as  the  net  capital  of 
the  partnership. 

In  the  case  of  so-called  limited  partnerships  the  relationship  of 
debtor  and  creditor  between  the  partnership  entity  and  individual 
partners  may  or  may  not  exist,  depending  on  the  facts  and  on 
state  laws.^  If  the  subordination  is  of  a  temporary  character 
the  limitation  should  be  clearly  shown.  In  one  case  it  was  con- 
tended that  an  agreement  to  subordinate  the  debt  due  to  a  large 
stockholder  might  be  withdrawn  at  any  time,  and  new  creditors 
might  lose  the  benefit.  The  author  suggested  that  the  sub- 
ordination agreement  be  made  irrevocable  and  lodged  with  one 
of  the  federal  reserve  banks.  The  suggestion  was  found  to  be 
feasible  and  was  adopted. 

Accounts  Payable 

The  term  "accounts  payable"  includes  all  debts  and  obli- 
gations due  and  not  due  which  are  not  evidenced  by  notes,  bonds, 
acceptances,  or  other  specific  promises  to  pay  which  in  them- 
selves recognize  the  debts  due  to  others.  The  term  includes 
all  debts  due  on  open  accoimt  for  operating  and  capital  purposes 
as  well  as  for  accrued  expenses,  interest  due  or  accrued,  and 
taxes  due  or  accrued;  accrued  items  are  usually  grouped  under 
a  separate  caption  called  "accrued  liabilities."  As  a  separate 
item  there  should  be  included  amounts  received  in  advance  for 


5  For  discussion  of  this  point,  see  Income  Tax  Procedure,  1921,  page  626 
et  seq. 


VOL. I — IS 


225  AUDITING— GENERAL  PRINCIPLES 

goods  not  shipped,  advance  rentals,  and  items  for  similar  pur- 
poses. It  may  be  that  cash  is  not  to  be  paid  in  respect  of  these 
items,  but  it  must  be  assumed  that  the  accounts  will  be  liqui- 
dated in  due  course  by  the  transfer  of  goods,  services,  or  ade- 
quate consideration.  When  it  is  known  that  payment  in  cash 
or  other  property  will  not  be  made  within  a  year,  long-time 
obHgations  may  be  separated.  In  arriving  at  net  current  as- 
sets, long-time  liabihties  need  not  be  deducted  from  the  gross 
assets. 

The  ideal  course  by  which  to  satisfy  one's  self  that  all  obliga- 
tions to  trade  creditors  appear  in  the  books  at  the  balance  sheet 
date  would  be  to  read  all  the  incoming  mail  for  some  days  before 
and  after  such  date.  The  period  prior  would  yield  information 
as  to  the  original  invoices  for  purchases,  and  during  the  subse- 
quent days  ordinary  monthly  statements,  followed  later  by  polite 
requests  to  pay,  show  practically  all  of  the  class  of  debts  men- 
tioned. The  mail  likewise  brings  notices  of  maturities  of 
promissory  notes. 

Unfortunately,  the  auditor  rarely  has  an  opportunity  to 
open  the  mail  of  his  clients,  although  it  might  shed  light  on 
more  items  than  accounts  and  notes  payable.  In  the  absence  of 
this  short-cut  an  auditor  must  first  see  to  it  that  all  the  accounts 
payable  shown  on,  or  indicated  by,  the  books  are  reflected  in  the 
balance  sheet,  and,  second,  he  must  conduct  a  proper  investigation 
to  ascertain  whether  any  accounts  payable  actually  owing  by  the 
concern  under  audit  and  not  shown  on  the  books,  should 
be  included  among  the  HabiH ties.  The  procedure  in  such  an 
investigation  is  explained  hereafter. 

Proper  Classification. — The  auditor  cannot  foresee  the  use 
to  which  a  balance  sheet  may  be  put,  so  that  it  is  always  his  duty 
to  use  plain  terms  and  so  to  classify  the  Habilities  that  any  perti- 
nent question  which  arises  in  the  mind  of  an  interested  person  may 
be  answered  without  the  necessity  of  a  special  examination  for 
each  question.     It  is  not  enough  to  state  the  aggregate  of  the 


BALANCE  SHEET  AUDIT— LIABILITIES  227 

debts  of  a  firm  or  corporation,  unless  it  is  to  be  understood  that 
all  consist  of  open  accounts  payable,  incurred  in  the  regular 
course  of  business,  not  due,  and  for  which  value  has  been  received. 
If  various  classes  of  debts,  incurred  in  other  than  the  regular 
course  of  business,  are  included  in  one  sum,  it  is  impossible  for 
anyone  not  familiar  with  the  facts  to  express  a  rehable  opinion 
upon  the  financial  position  of  the  concern . 

For  instance,  it  may  appear  that  a  firm  has  assets  amounting 
to  $1,000,000,  consisting  chiefly  of  accounts  and  stock-in-trade, 
and  has  accounts  payable  amounting  to  $250,000.  If  the  latter 
are  not  due  it  is  fair  to  infer  that  the  accounts  receivable  and 
merchandise  stock  can  be  liquidated  quickly  enough  to  pay  the 
obligations  as  they  mature.  But  suppose  it  is  shown  that  some  of 
the  accounts  payable  are  long  overdue;  that  the  accounts  receiv- 
able are  very  slow;  that  the  merchandise  stock  is  selling  poorly; 
and  that  cash  receipts  are  being  used  to  pay  wages  and  similar 
expenses.  Does  this  make  a  favorable  showing  in  the  eyes  of  a 
banker  who  may  be  considering  the  advisability  of  extending  a 
line  of  credit? 

Of  course  a  firm  in  such  a  condition  may  deserve  the  con- 
fidence of  a  banker,  and  there  may  be  ample  security  for  a 
reasonable  Kne  of  credit,  but  no  auditor  is  justified  in  merely 
stating  the  bald  facts  as  shown.  If  the  auditor  does  not  feel 
warranted  in  adding  a  few  words  of  comment  to  convey  un- 
equivocally the  fact  that  the  assets  are  not  readily  reahzable  and 
that  the  accounts  payable  are  long  overdue,  then  his  point  of 
view  is  too  far  apart  from  the  author's.  The  auditor  whose 
conception  of  his  duty  is  that  it  requires  him  to  state  so-called 
facts  only,  is  not  performing  useful  professional  services.  The 
principal  reason  why  some  business  men  feel  that  professional 
auditors  cannot  help  them  is  that  they  have  been  unfortunate 
enough  to  hear  the  words  and  see  the  figures  compiled  by  an 
auditor  who  felt  that  he  exceeded  the  limits  of  propriety  if  he 
ventured  an  opinion  upon  any  important  item  of  the  balance 
sheet. 


228  AUDITING— GENERAL  PRINCIPLES 

Items  Omitted. — It  is  a  reasonable  assumption  that  no 
balance  sheet  prepared  within,  say,  twenty  days  of  a  certain  date, 
exhibits  every  liability  as  of  that  date.  No  exception  is  made 
of  those  concerns  which  maintain  an  inflexible  order  system  and 
whose  books  are  not  closed  until  every  order  issued  is  represented 
by  a  purchase  invoice.  It  is  always  found  that  someone  has 
ignored  the  rules  and  ordered  something  for  which  a  Hability 
exists,  and  it  may  be  that  a  liability  has  been  incurred  for  an 
expense  which  does  not  require  an  order,  such  as  long-distance 
telephone  calls  or  lawyers'  bills.  Taxes  concerning  which  little  is 
known  may  be  accruing,  or  goods  may  not  have  been  delivered 
to  a  customer  because  he  has  refused  to  accept  them,  and  return 
freight  charges  and  storage  may  have  accrued.  The  best  the 
auditor  can  do  is  to  schedule  all  of  the  liabilities  to  which  he  can 
find  the  shghtest  clue. 

So  many  balance  sheets  are  issued  which  fail  to  include  all 
Habilities  that  the  author  feels  justified  in  discussing  the  matter 
fully,  in  order  that  the  student  may  have  the  benefit  of  accumu- 
lated experience. 

Trade  Creditors 

This  may  not  be  the  largest  item  of  the  HabiHties,  but  it 
is  clearly  the  most  important  to  verify.  The  notes  payable 
outstanding  may  be  larger  in  amount,  but  the  proceeds  thereof 
were  presumably  used  to  discharge  trade  debts,  so  that  the  latter 
item  loses  none  of  its  importance  because  the  balance  is  small. 

As  already  stated,  an  auditor  may  ascertain  the  total  amount 
of  the  debts  by  examining  all  of  the  mail  over  a  sufficiently  long 
period,  but  if  this  procedure  is  out  of  the  question,  he  must  do 
the  next  best  thing. 

Creditors'  Statements. — Statements  from  creditors  are 
valuable  in  verifying  the  amount  due  or  claimed  to  be  due,  and, 
if  the  time  permits  (it  usually  does  not),  the  auditor  can  do  no 
better  than  to  request  a  statement  from  everyone  with  whom  the 


BALANCE  SHEET  AUDIT— LIABILITIES  229 

concern  may  be  expected  to  do  business.  Even  then  some- 
one from  whom  a  purchase  had  been  made  may  be  forgotten  and 
the  invoice  may  be  omitted  from  the  books,  and  the  fact  con- 
cealed from  the  auditor. 

Several  cases  have  come  to  the  author's  attention  of  defal- 
cations which  arose  through  the  changing  of  the  names  of  the 
payees  on  cheques  and  the  inserting  of  the  name  of  the  defaulter. 
In  such  cases  it  is  quite  possible  that  a  request  for  statements 
from  creditors  and  a  comparison  of  such  statements  with  the 
ledger  accounts  would  have  brought  to  light  the  defalcation. 

Suppressed  Invoices. — Most  concerns  keep  order  and  receiv- 
ing records  of  some  description.  The  auditor  should  compare 
the  entries  in  these  records  during  the  period  immediately  preced- 
ing the  balance  sheet  date,  with  the  purchase  journal  or  voucher 
record,  to  ascertain  if  the  purchases  indicated  are  entered.  All 
entries  need  not  be  checked.  It  is  necessary  to  test  only  enough 
of  the  work  to  satisfy  one's  self  that  no  invoices  have  knowingly 
or  unknowingly  been  suppressed. 

If  an  audit  is  not  completed  until  more  than  a  month  has 
elapsed  after  the  closing  date,  the  voucher  record  should  be 
scrutinized  to  ascertain  whether  invoices  entered  subsequently 
belong  to  the  prior  period. 

Irregular  Items. — The  open  accounts  on  the  ledger  should 
be  compared  with  the  schedule  of  accoimts  payable.  It  should 
be  ascertained  that  the  balances  represent  specific  and  recent 
items  only.  If  not,  why  not?  Where  any  account  does  not  look 
regular  in  every  way,  the  creditor's  statement  should  be  asked 
for.  If  it  cannot  be  found,  request  a  dupHcate.  If  told  that  the 
creditor  does  not  send  statements,  demand  that  one  be  procured. 
The  latter  excuse  is  often  made,  but  almost  invariably  it  follows 
an  inquiry  relative  to  a  disputed  account  and  the  ledger 
shows  a  less  amount  to  be  due  than  is  claimed.  Nearly  all 
business  houses  do  send  statements  either  on  a  fixed  day  each 
month  or  as  bills  fall  due.    The  author  has  never  heard  of  a 


230  AUDITING— GENERAL  PRINCIPLES 

refusal  to  furnish  either  a  duplicate  or  a  memorandum  of  the 
amount  due  at  any  stated  time. 

Tests. — As  a  test,  call  for  certain  statements  in  every  audit, 
even  if  none  of  the  accounts  appears  to  be  irregular.  Disputes 
regarding  discounts,  allowances,  returns,  etc.,  occur  so  frequently 
that  it  may  be  the  auditor's  only  chance  to  test  the  reliability  of 
the  purchase  records. 

Order  and  Receiving  Books. — ^An  inspection  of  the  order 
and  receiving  books  is  also  important  because  it  may  disclose 
receipts  of  goods  at  or  before  inventory  time  the  invoices  for 
which  are  not  entered,  the  reason  given  for  the  omission  being 
that  as  the  goods  were  received  late  it  was  not  considered  worth 
while  to  add  them  to  the  inventories,  or  to  pass  the  invoices 
through  the  books  until  after  the  closing  date.  If  this  practice 
involves  a  few  items  of  small  amount  only,  it  is  not  worth  con- 
demning, but  if  the  quantities  and  amounts  are  relatively  large 
the  auditor  must  add  the  goods  to  the  inventory  and  the  amounts 
of  the  invoices  to  the  accounts  payable. 

When  examining  the  receiving  and  other  records  for  evidence 
of  purchases  not  represented  by  entries  in  the  books,  it  should  be 
remembered  that  the  date  of  an  invoice  may  not  represent  the 
date  of  its  shipment,  the  practice  of  ''dating"  (i.e.,  dating  an 
invoice  forward  to  some  future  time)  being  not  at  all  imcommon. 

Goods  Received  for  New  Season's  Operations. — In  many 
cases  balance  sheets  are  made  up  at  a  time  when  there  is  supposed 
to  be  a  "clean  up."  Inventories  should  be  at  the  lowest  point 
of  the  year.  It  sometimes  happens  that  goods  ordered  long  in 
advance  to  be  used  in  succeeding  periods  have  been  received  prior 
to  the  inventory  date.  In  some  cases,  auditors  have  consented 
to  add  a  footnote  to  the  balance  sheet  stating  part  of  the  facts 
and  omitting  the  aggregate  purchase  price  of  the  goods  received. 
Concerns  are  ill-advised  when  it  is  assumed  that  such  a  footnote 
creates  a  more  favorable  impression  than  the  inclusion  of  the 


BALANCE  SHEET  AUDIT— LIABILITIES  23 1 

goods  in  the  inventory  and  the  liabilities  in  the  accounts  payable. 
There  is  no  objection  to  segregating  the  inventory  from  other 
items  if  it  is  deemed  to  be  desirable.  Under  no  circumstances  is 
an  auditor  justified  in  omitting  a  reference  to  the  facts.  So  long 
as  reference  must  be  made,  it  is  better  to  incorporate  the  items 
in  the  usual  groups  and  obviate  the  need  for  special  reference. 

Trade  and  Cash  Discounts. — It  is  assumed  that  the  ledger 
balances  represent  the  amounts  due  after  trade  discounts  have 
been  deducted  but  before  cash  discounts  are  taken  into  consider- 
ation. Trade  discounts  should  not  appear  on  the  books  of  ac- 
count; as  they  are  direct  deductions  from  list  prices,  they  should 
be  deducted  before  entry  of  the  purchase  invoices  to  which  they 
apply.  Regarding  cash  discounts,  however,  the  practice  is  not 
uniform.  Some  concerns  take  advantage  of  every  cash  discount 
and  make  the  deduction  immediately  upon  receipt  of  the  invoice 
and  before  it  is  entered.  Where  this  is  done  the  auditor  need  not 
hesitate  to  pass  the  accounts  as  they  stand,  but  where  the  deduc- 
tions have  not  been  made  the  auditor  should  be  governed  by  the 
size  of  the  discounts.  Where  the  allowance  is  2  per  cent  for 
payment  within  ten  days,  or  where  the  rate  is  lower,  the  amoimts 
due  should  be  taken  at  their  face.  This  gives  the  period  following 
the  balance  sheet  date  the  benefit  of  the  earning,  but  it  is  not  out 
of  proportion  to  the  cash  required  and  the  expense  of  salaries, 
postage,  etc.,  incurred.  On  the  other  hand,  if  the  allowance  is 
more  than  2  per  cent  for  prepayment,  and  if  the  concern  has 
ample  funds  to  pay  all  maturing  accounts,  it  may  reasonably  be 
urged  that  the  earning  belongs  to  the  period  preceding  the  closing 
of  the  books.  For  instance,  an  invoice  for  $1,000  may  be  dated 
June  23,  "thirty  days  net,  3  per  cent  ten  days."  It  can  hardly 
be  urged  that  on  June  30  the  Habihty  will  be  more  than  $970, 
provided  that  the  cash  balance  indicates  that  the  discount  will  be 
taken  advantage  of. 

If  the  auditor  desires  to  adjust  the  accounts  in  accordance 
with  this  suggestion,  it  is  necessary  only  to  note  the  actual 


232  AUDITING— GENERAL  PRINCIPLES 

deductions,  per  cash  book,  during,  say,  the  first  half  month 
succeeding  the  balance  sheet  date,  allowing  for  any  possible  items 
arising  out  of  new  transactions.  This  obviates  the  necessity  of 
calculating  the  amount  in  detail. 

As  a  matter  of  general  practice  an  auditor  does  not  care  to 
take  advantage  of  this  opportunity  to  reduce  the  liabilities,  since 
there  are  possible  deductions  from  assets  which  usually  more  than 
offset  this  amount;  but  if  the  greatest  exactness  is  required,  or  if 
there  is  any  evidence  of  a  desire  to  understate  the  net  worth  of  a 
concern  by  undervaluing  the  assets,  it  may  be  necessary  to  apply 
the  same  principles  to  the  liabiHties.  Or  again,  a  concern  doing 
a  very  large  business,  such  as  a  department  store,  may  allow  no 
cash  discoimts  to  customers  but  may  exact  them  from  its  creditors. 
In  such  a  case  the  adjustment  suggested  may  make  a  material 
change  in  the  balance  sheet. 

Liabilities  for  Goods  Received  on  Consignment 

If  the  business  under  audit  is  one  in  which  there  is  a  possibility 
that  all  or  part  of  goods  received  on  consignment  have  been  sold 
without  any  liability  therefor  having  been  recorded  in  the  books, 
the  auditor  must  use  all  due  diHgence  to  cover  the  point  fully. 
Instances  have  been  known  where  concerns  have  sold  and  col- 
lected for  consigned  goods  without  making  any  record  of  the 
liabiHty  until  payment  was  made.  This  may  occur  when  owned 
and  consigned  stock-in-trade  are  mingled  and  a  general  sales 
account  is  credited  as  sales  are  made.  There  may  be  no  intention 
to  deceive,  since  consignment  accounts  are  usually  treated  as 
memoranda  only. 

If  inquiry  develops  the  fact  that  goods  have  been  received 
on  consignment,  all  records  in  connection  therewith  should  be 
called  for.  If  the  goods  have  all  been  sold,  the  consignor's 
accoimt  should  show  the  full  amount  due  and,  if  the  debt  is  a 
current  one,  the  amount  should  appear  among  those  due  to 
trade  creditors. 

If  it  appears  that  the  consigned  goods  are  partly  sold  and 


BALANCE  SHEET  AUDIT— LIABILITIES  233 

partly  on  hand,  a  memorandum  or  *'pro  forma"  account  sale 
should  be  made  up  for  the  part  of  each  lot  disposed  of  but  not  yet 
accounted  for.  The  net  proceeds  due  to  the  consignors  should 
be  entered  as  a  liability  in  the  account,  "accounts  payable 
consignors."  As  some  time  may  elapse  before  payment,  it  is 
not  necessary  to  include  the  aggregate  among  the  trade  creditors, 
except  as  a  liabiHty  accrued,  but  not  due.  When  the  books  are 
reopened,  the  entries  for  uncompleted  consignments  should 
be  reversed. 

Notes  Payable 

It  is  usual  and  desirable  to  divide  the  aggregate  of  notes 
payable  into : 

1.  Notes  issued  for  merchandise. 

2.  Notes  discounted  by  cHent's  own  banks. 

3.  Notes  sold  through  brokers. 

4.  Demand  loans. 

A  further  separation  which  is  not  often  seen,  but  which  is  most 
desirable,  is: 

1 .  Notes  accompanied  by  collateral. 

2.  Notes  not  accompanied  by  collateral. 

When  notes  are  secured  by  collateral,  the  auditor  should 
verify  the  existence  of  the  collateral  by  correspondence  with  the 
holders  thereof. 

There  is  not  much  to  say  on  the  procedure  involved  in  verifying 
the  existence  of  outstanding,  unpaid  promissory  notes  except  to 
warn  the  auditor  that  a  great  many  instances  have  been  known  in 
which  outstanding  notes  were  not  shown  as  liabilities  on  books  of 
account. 

Concealment. — It  may  safely  be  said  that,  if  deception  is 
intended,  so  far  as  the  concealment  of  liabiHties  is  concerned 
there  is  a  greater  likeHhood  of  its  existing  in  connection  with  notes 
payable  than  with  accounts  payable.    The  latter  are  usually 


234  AUDITING— GENERAL  PRINCIPLES 

evidenced  by  invoices,  and  any  attempt  to  hold  them  out  attracts 
suspicion  on  the  part  of  the  office  staff.  With  notes,  however,  it 
is  comparatively  easy  to  secure  discounts,  secrete  the  proceeds, 
and  make  no  entry  therefor  on  the  books.  This  omission  is  more 
difficult  to  detect  in,  and  probably  occurs  more  frequently  in 
connection  with,  single-entry  than  double-entry  books. 

The  point  is  of  special  importance  where  audits  are  made  for 
the  benefit  of  prospective  lenders  of  money.  The  borrower  tries 
to  increase  his  assets  and  to  decrease  his  Habihties  to  the  greatest 
possible  extent.  He  also  may  attempt  to  conceal  the  fact  that 
he  has  issued  notes  and  may  be  carrying  open  accounts  on  the 
books,  while  in  reality  notes  have  been  issued  therefor  which  are 
falling  due  or  which  are  overdue  and  unpaid. 

In  a  recent  bankruptcy  case  it  was  disclosed  that  a  large 
number  of  notes  had  been  given  to  creditors  without  any  record 
thereof  appearing  in  the  books.  The  notes  bore  interest  and 
several  creditors  had  secured  judgment  for  non-payment.  As 
the  interest  and  costs  amounted  to  a  considerable  sum,  the  habili- 
ties  were  increased  accordingly. 

A  more  dangerous  type  of  concealment  exists  when  notes 
are  issued  in  the  firm  or  corporate  name  for  money  borrowed  by 
individuals  and  then  pass  into  the  hands  of  innocent  holders,  who, 
of  course,  can  collect  if  the  concern  is  solvent.  Notes  of  this 
description  are  sometimes  renewed  many  times  before  discovery. 
An  auditor  who  examines  the  books  of  account  in  the  meantime 
is  not  likely  to  find  any  trace  thereof.  The  auditor  should  in  all 
cases  ask  each  bank  with  which  the  concern  under  audit  is,  or 
may  be,  doing  business  what,  if  any,  obHgations  it  holds  which  the 
concern  may  have  to  pay. 

Discounted  Notes. — If  the  notes  are  discounted  by  one  of 
the  regular  banks,  it  seems  that  the  auditor,  as  well  as  the  office 
staff,  is  put  on  notice.  This  liabiHty  is  often  concealed  by  a 
statement  to  the  staff  to  the  effect  that  the  discount  is  a  personal 
loan  to  a  partner  or  officer.     The  auditor  may  secure  a  clue, 


BALANCE  SHEET  AUDIT— LIABILITIES  235 

or  at  least  grounds  for  suspicion,  if  he  traces  back  to  its  source 
every  credit  of  cash  to  the  account  of  a  partner  or  officer  of  the 
corporation.  As  a  matter  of  fact  so  many  so-called  loans  of  this 
nature  are  made  that  an  auditor  may  with  propriety  ask  the 
question  in  connection  with  every  such  loan:  ** Where  did  you 
get  it?"  In  other  words,  the  credits  to  the  individual  accounts 
of  partners  or  officers  may  represent  items  which  are  in  fact 
habihties  of  the  firm  or  corporation. 

The  Interest  Rate  on  Liabilities. — This  question  has  been 
asked:  "Should  the  interest  rate  be  shown  on  a  balance  sheet 
when  the  contract  rate  substantially  exceeds  the  legal  or  ruling 
rate?  "  In  the  author's  opinion  the  rate  should  not  be  shown  on 
the  balance  sheet.  It  may  be  of  interest  to  creditors  but  it  is  of 
more  interest  to  competitors  and  the  possibility  of  unfavorable 
reaction  outweighs  the  desirabihty.  Usually  such  conditions 
have  mitigating  or  compensating  features  which  cannot  be 
explained  on  balance  sheets;  the  necessary  omission  of  the 
explanation  renders  it  necessary  to  omit  the  mere  fact. 

Mortgages 

As  a  mortgage  derives  special  value  from  the  fact  that  upon 
registry  it  becomes  a  lien,  the  auditor  has  an  opportunity  to  verify 
the  existence  of  such  an  obligation  by  inspecting  the  public 
records.  Auditors  admit  the  value  of  the  knowledge  which  such 
an  inspection  discloses,  but  very  properly  urge  that  special  train- 
ing is  necessary  to  undertake  the  task. 

Law  Involved. — All  agree  that  to  be  a  well-equipped  auditor 
one  must  have  some  knowledge  of  law.  An  important  branch  of 
such  necessary  knowledge  is  that  pertaining  to  negotiable  and 
non-negotiable  instruments,  mortgages,  deeds,  contracts,  etc. 
A  reasonably  intelligent  auditor  or  audit  clerk  can  ascertain  the 
procedure  of  the  public  registry  ofhce  in  less  than  an  hour,  and  a 
search  for  unsatisfied  mortgages  or  judgments  can  be  made 
in  less  time  than  it  takes  to  verify  the  footings  of  a  voucher 


236  AUDITING— GENERAL  PRINCIPLES 

register,  and  is  an  immeasurably  more  important  thing  to  do.  If 
the  auditor  is  timid  about  undertaking  the  job,  it  may  be  worth 
while  to  arrange  with  a  local  lawyer  or  title  company  which  for  a 
small  fee  will  report  to  him  any  mortgages  or  judgments  entered 
against  his  cHents. 

So  much  for  a  purely  independent  search.  If  the  auditor 
feels  justified  in  accepting  the  book  record  as  to  the  existence 
of  a  mortgage,  he  should  at  least  endeavor  to  verify  the  amount, 
the  rate,  the  due  date,  and  the  property  secured  thereby.  All 
of  these  points  are  of  interest  to  those  who  may  desire  to  refer 
to  the  balance  sheet  of  the  mortgagor. 

Recording  Payments. — It  should  be  borne  in  mind  that  a 
payment  on  accoimt  of  a  mortgage  must  be  recorded  or  the  entire 
amoimt  will  remain  an  encumbrance  on  the  property.  There- 
fore, if  pa5anents  on  account  appear,  the  auditor  should  ascertain 
if  the  principal  has  been  legally  reduced;  if  not,  the  fact  should 
appear  on  the  balance  sheet. 

Manner  of  Stating. — The  auditor  should  so  state  the 
mortgages  that  one  can  determine  at  a  glance  whether  property 
was  bought  subject  to  a  mortgage  on  which  someone  else  is  Hable, 
or  whether  the  mortgage  was  executed  by  the  client.  In  the 
former  case  the  client  can  be  liable  only  to  the  extent  of  the  value 
of  the  property,  and  therefore  on  the  balance  sheet  the  mortgage 
should  be  deducted  from  the  value  of  the  property  on  the  asset  side. 
In  the  latter  case  the  client  may  be  held  liable  through  a  deficiency 
judgment  for  the  excess  of  mortgage,  interest,  expenses,  etc.,  over 
the  amount  reahzed  from  the  sale  of  the  property.  In  such  case 
the  mortgage  should  be  stated  on  the  balance  sheet  as  a  liability. 

Bonds 

So  many  different  classes  of  bonds  have  been  evolved  by  the 
fertile  brains  of  financiers  that  no  attempt  will  be  made  here  to 
differentiate  except  in  a  general  way. 

Bonds  secured  by  a  mortgage  upon  real  estate  are,  excluding 


BALANCE  SHEET  AUDIT— LIABILITIES  237 

government  bonds,  the  most  popular  with  investors.  At  one 
time  all  bonds,  if  not  otherwise  designated,  were  presumed  to  be 
secured  by  real  property,  but  today  many  issues  of  bonds  are 
mere  promissory  notes,  differing  only  from  the  usual  form  of  the 
latter  in  that  they  are  larger  in  form,  have  coupons  attached,  are 
sealed,  and  are  also  less  valuable  because  they  do  not  fall  due  for 
a  considerable  period.  From  the  auditor's  point  of  view  the 
security  is  important  because  of  its  bearing  on  other  obHgations 
and  because  of  the  equity,  if  any,  which  exists  for  a  subsequent 
lender  or  creditor. 

As  a  rule,  balance  sheets  are  deficient  in  the  information 
which  they  impart  with  reference  to  the  real  estate  or  personal 
property  which  is  pledged  with  an  issue  of  bonds.  Sometimes 
a  bond  is  a  first  lien  on  certain  assets  and  a  second  lien  on  others. 
It  may  not  be  possible  to  explain  in  a  condensed  balance  sheet  the 
items  or  properties  which  are  pledged  under  a  mortgage;  but  if  it 
is  feasible  to  have  a  balance  sheet  disclose  the  position  which  a 
bond  bears  to  the  assets,  it  is  the  auditor's  duty  so  to  state  it. 
In  any  event  he  should  determine  as  nearly  as  possible  the  posi- 
tion, if  it  is  not  so  disclosed. 

Corporations  which  issue  bonds  should,  and  in  most  cases  do, 
keep  a  copy  or  sample  thereof.  The  auditor  should  read  this 
carefully  in  connection  with  the  mortgage  or  deed  of  trust,  make 
an  abstract  of  these  documents,  and  note  all  references  to  interest 
rate  (or  rates,  since  changes  are  sometimes  made),  due  date  or 
dates  (instalments  of  principal  are  frequently  provided  for), 
property  pledged,  sinking  fund  or  similar  provisions,  and  in  fact 
anything  which  relates  to  the  accounts  or  financial  transactions  of 
the  maker. 

When  considering  the  matter  of  liens  it  should  be  noted  that 
usually  unpaid  interest  is  a  lien  equal  to  the  unpaid  principal. 

Rules  Which  Govern  Loans 

The  following  rules  relative  to  the  borrowing  and  loaning  of 
money  were  prepared  by  very  able  authorities: 


238  AUDITING— GENERAL  PRINCIPLES 

1.  The  purpose  for  which  the  borrowed  money  is  to  be 

used  should  produce  a  return  greater  than  is  needed 
to  pay  the  debt. 

2.  The  length  of  time  the  debt  is  to  run  should  not  exceed 

the  productive  life  of  the  improvement  for  which  the 
money  is  borrowed. 

3.  Provision  should  be  made  in  case  of  long-time  loans  for 

the  gradual  reduction  of  the  principal. 

Judgments 

It  frequently  happens  that  a  prosperous  concern  disputes  a 
claim,  litigates  it,  and  has  judgment  entered  against  it.  If  the 
case  is  appealed  the  judgment  may  be  allowed  to  stand  or  a  bond 
may  be  given  pending  a  final  decision.  In  rare  instances  are 
these  debts  entered  on  the  books.  Most  business  men  consider 
that  the  entry  of  an  invoice  is  an  admission  of  liability,  and  of 
course  will  not  permit  the  entry  of  a  claim  which  they  propose 
to  fight. 

What  position  must  the  auditor  take?  If  a  balance  sheet 
is  being  constructed,  the  amount  of  the  judgment  should  be 
included  as  a  liability,  or  a  reserve  should  be  set  up  to  cover 
the  estimated  liability  under  the  claim.  If  a  balance  sheet 
has  been  completed,  the  auditor  should  call  attention  thereto  in 
a  footnote. 

How  is  the  auditor  to  secure  information  as  to  the  existence 
of  judgments?  As  mentioned  under  mortgages,^  he  himself 
should  be  able  to  examine  the  public  record.  If  he  is  not  willing 
to  do  this,  he  should  make  such  inquiry  or  investigation  as  is 
feasible.  An  inspection  of  lawyers'  bills  is  a  good  way  to  secure  a 
clue.  If  a  concern  is  able  to  pay  but  does  not  do  so  on  principle, 
the  auditor  will  have  no  difficulty  in  learning  the  facts.  If  a 
concern  is  obviously  hard  up,  the  auditor  is  charged  with  con- 
structive knowledge  that  judgments  have  been  obtained,  and  he 


6  Page  235. 


BALANCE  SHEET  AUDIT— LIABILITIES  239 

is  not  safe  unless  he  secures  a  report  based  on  a  search.  Even 
if  the  search  costs  a  few  dollars  the  expense  will  be  well  worth 
while.  If  the  audit  is  made  for  a  banker,  the  latter  may  have  had 
a  search  made,  or,  if  not,  will  on  request  do  so  through  his  own 
attorney. 

Interest  Payable 

Many  of  the  liabilities  which  appear  on  a  balance  sheet 
carry  interest,  therefore  the  calculation  of  accrued  interest  to 
the  date  of  the  balance  sheet  is  an  important  matter.  The 
auditor  should  consider  the  possibility  of  an  accrual  on  accoimts 
payable  as  well  as  on  notes  payable,  bonds,  etc.  Enough  book 
accounts  bear  interest  to  warrant  an  inquiry  into  the  possibility 
of  its  existence. 

Loan  accounts  of  partners  and  officers  of  corporations  almost 
invariably  bear  interest,  but  it  is  not  always  calculated  to  the 
date  of  closing  the  books.  Judgments,  overdue  taxes,  and  other 
liens,  sometimes  bear  interest  at  extremely  high  rates. 

Legally,  the  interest  on  bonds  (except  income  and  similar 
bonds)  is  secured  by  the  same  property  as  the  principal  and  in 
effect  becomes  part  of  the  principal,  but  the  latter  is  a  long-term 
obligation,  while  interest  is  payable  at  frequent  intervals  and 
should  therefore  appear  as  a  current  liability. 

Taxes 

Bond  interest  which  accrues  from  July  i  to  December  31, 
and  which  is  payable  on  January  i,  always  appears  among  the 
Habilities  on  December  31,  assuming,  of  course,  that  a  proper 
system  of  accounts  is  in  force.  The  federal  tax  accrues  as  of 
December  31,  or  at  the  end  of  the  fiscal  year,  just  as  surely  as  any 
other  item. 

The  balance  sheet  of  a  commercial  enterprise,  prior  to  the 
enactment  of  the  federal  excess  profits  and  federal  and  state 
income  and  franchise  tax  laws,  rarely  included  a  liability  for 
accrued  taxes  unless  real  estate  was  owned.    Under  the  laws 


240  AUDITING— GENERAL  PRINCIPLES 

mentioned,  taxes  are  imposed  upon  the  net  profits  of  corporations/ 
This  tax  must  be  paid  even  if  a  corporation  is  dissolved  before  the 
end  of  the  year  for  which  the  tax  is  imposed.  Since  the  tax  is 
specifically  based  on  the  net  profits  of  a  particular  period, 
although  payable  some  months  thereafter,  the  tax  accrues 
throughout  such  specific  period;  consequently,  if  a  net  profit  is 
disclosed  upon  the  closing  of  the  books,  an  adequate  reserve 
should  be  provided  therefor.  The  auditor  should  insist  that 
such  a  reserve  appear  among  the  liabilities  and  should  refuse  to 
certify  the  balance  sheet  if  it  is  omitted.  Unfortunately,  there 
is  a  tendency  in  some  quarters  to  treat  accrued  taxes  as  a  reserve 
or  as  a  possible  liability  rather  than  as  an  actual  debt  to  be  paid  in 
cash  on  fixed  dates. 

The  question  arises  as  to  whether  the  auditor,  when  making  a 
first  examination,  should  determine  if  there  is  a  likelihood  of 
additional  assessments  on  the  taxes  paid  for  the  years  prior  to 
that  under  examination.  As  the  auditor  can  satisfy  himself  in 
the  majority  of  cases  in  a  short  time  whether  there  appears  to  be 
a  material  liabiHty  for  additional  taxes,  it  would  seem  that  he 
should  make  at  least  a  test  to  determine  whether  such  a  liability 
exists.  If  he  is  not  allowed  to  make  such  a  test,  he  should  protect 
himself  by  inserting  a  notation  on  the  balance  sheet  to  the  effect 
that  the  question  of  additional  liability  on  taxes  for  previous 
years  was  not  considered.  Inspection  of  the  published  balance 
sheets  of  many  well-known  corporations  indicates  that  the  prac- 
tice of  providing  adequate  tax  reserves  is  general.  In  many  cases 
the  statement  is  made  that  the  liability  has  not  been  determined, 
that  it  is  estimated,  but  that  the  estimate  is  beheved  to  be  ample. 
Therefore  it  is  good  accounting  practice  to  state  the  amount 
of  the  estimated  accrual  rather  than  to  omit  the  liabihty  because 
it  is  difficult  to  make  an  estimate. 

A  corporation  which  had  made  a  large  temporary  profit  was 
dissolved  in  July.  A  balance  sheet  was  prepared  and  on  its 
showing,  a  distribution  of  capital  and  profits  was  made.  In  the 
following  February  the  government  demanded  a  tax  return  and 


BALANCE  SHEET  AUDIT— LIABILITIES  241 

payment  of  the  unpaid  tax.     One  of  the  directors  had  to  pay 
the  assessment. 

The  matter  of  taxes  is  of  particular  importance  in  all  audits  of 
public  service  corporations,  but  the  auditor  should  consider  the 
possible  liability  for  taxes  before  finally  passing  upon  any  balance 
sheet. 

Water  Rates,  etc. 

There  are  certain  expenses,  such  as  gas  and  water,  the  bills  for 
which  are  frequently  rendered  at  long  intervals.  The  audit 
should  provide  for  all  accrued  expenses  of  this  class. 

Insurance 

The  liability  for  premiums  on  insurance  taken,  but  for  which 
no  entries  have  been  made,  should  be  included.  Special  atten- 
tion should  be  paid  to  premiums  on  employees'  liability  insurance 
policies  which  are  generally  based  on  the  pay-roll  and  for  which 
in  many  cases  the  liability  has  not  been  calculated  or  billed  to  the 
date  of  the  audit. 

Wages 

The  date  of  the  balance  sheet  does  not  always  coincide  with 
the  date  to  which  a  pay-roll  is  calculated.  The  amount  accrued 
should  be  ascertained  and  entered  as  a  liability,  unless  it  is  trifling. 

If  there  is  little  fluctuation  in  the  number  of  men  employed,  it 
is  sufficient  to  take  the  proportion  of  the  full  week's  pay-roll;  i.e., 
if  the  next  succeeding  pay-roll  amounts  to  $1,000,  and  three  days 
accrue  in  each  period,  the  liability  can  be  stated  at  $500,  although 
each  day's  total  may  vary  a  few  dollars  from  the  others.  The 
difference  is  not  large  enough  to  pay  for  the  work  involved  in 
making  the  calculations. 

Rent 

Rent  is  usually  payable  in  advance.  If,  however,  any  is 
accrued  and  not  paid,  it  should  be  shown. 

VOL.  I — 16 


242  AUDITING— GENERAL  PRINCIPLES 

Freight 

Sales  are  frequently  made  on  a  basis  of  free  delivery  to 
destination,  and  current  freight  bills  are  sometimes  permitted  to 
run,  if  the  concern  is  well  known. 

An  allowance  of  freight  to  a  customer  should  be  treated  as  a 
deduction  from  amounts  due  from  trade  debtors. 

Goods  may  be  shipped,  refused,  and  returned,  in  which  case 
freight  charges  accrue. 

Traveling  Expenses  and  Commissions 

It  is  important  to  note  whether  the  accounts  of  all  traveling 
salesmen  are  received  and  entered  before  the  books  are  closed. 
The  auditor  should  secure  a  list  and,  if  any  report  was  not  so 
entered,  provision  therefor  should  be  made. 

Ample  provision  should  be  made  for  all  commissions  eventually 
payable  on  sales  which  have  been  billed  to  customers.  Since  com- 
missions are  frequently  not  payable  to  salesmen  until  the  sales  have 
been  collected  from  the  customers,  accrued  commissions  are  often 
omitted  from  the  books.  As  they  must,  however,  be  paid  from  the 
proceeds  of  the  sales  on  which  the  full  profit  has  already  been  taken 
into  the  accounts,  they  should  clearly  be  set  up  as  liabilities. 

Legal  Expenses 

All  concerns  have  more  or  less  litigation.  Lawyers  are  usually 
expensive,  but  they  have  the  merit,  if  it  can  be  so  termed,  of 
waiting  for  their  money.  Before  the  books  are  closed  the  lawyers 
should  be  requested  to  send  in  a  bill.  If  one  is  not  furnished, 
the  auditor  should  ascertain  the  amount  due,  if  any. 

Audit  Fees 

In  line  with  the  theory  that  all  accrued  expenses  must  be 
included  among  the  liabilities,  it  may  be  assumed  that  the  expense 
incurred  for  an  audit  to,  say,  June  30,  is  a  proper  charge  to  the 
period  prior  thereto.  In  practice,  however,  it  is  not  usual  to 
include  the  audit  fee  as  an  outstanding  liability  as  of  the  date  of 


BALANCE  SHEET  AUDIT— LIABILITIES  243 

the  balance  sheet.  If  the  auditor  does  not  perform  any  work 
on  the  accounts  until  after  the  closing  date,  it  is  certain  that  no 
legal  liability  therefor  exists  at  that  time. 

Under  ordinary  conditions  the  amount  of  the  fee  is  not  known 
until  after  the  report  is  written  and  submitted,  so  that  no  more 
than  an  estimate  can  be  included. 

Ordinarily  the  fee  is  not  such  a  liability  as  should  be  provided 
for,  if  the  audit  commences  after  the  closing  date.  An  exception 
should  be  made,  however,  in  cases  of  partnerships  or  close  corpora- 
tions from  which  a  partner  or  stockholder  is  about  to  retire.  The 
audit  being  partly  for  the  benefit  of  the  retiring  party,  and  he  being 
entitled  to  a  copy  of  the  report,  it  is  proper  that  a  sufficient  reserve 
be  set  aside  prior  to  the  closing  of  the  books,  to  provide  therefor. 

Employees'  Profit-Sharing  Plans 

Unless  otherwise  provided  for  federal  and  state  taxes  should 
always  be  deducted  before  arriving  at  the  amount  to  be  appor- 
tioned. '  The  net  amounts  due  should  appear  as  a  liability  in  the 
period  during  which  the  profits  accrue,  even  though  the  liability 
is  not  determined  until  a  later  date. 

Damages  and  Other  Unliquidated  Claims 

It  is  customary  to  insure  against  liability  for  damages  claimed 
by  employees  or  the  public,  but  few  insurance  pohcies,  if  any, 
assume  an  unlimited  liability.  Moreover,  all  concerns  do  not 
carry  such  insurance,  although  it  is  a  reflection  on  a  man's  busi- 
ness ability  to  neglect  such  protection.  Furthermore,  claims  for 
damages  may  arise  out  of  alleged  breach  of  contract,  or  failure  to 
deliver  goods,  or  for  any  one  of  many  other  reasons. 

The  auditor  should  inquire  as  to  this  possible  Hability  and 
should  also  request  that  a  letter  be  procured  from  the  concern's 
attorneys  stating  or  commenting  on  any  pending  claims  or  suits. 

It  may  be  that  claims  have  arisen  which  have  not  been  referred 


7  For  full  discussion  of  this  question  and  formula  for  ascertaining  amounts 
due,  see  Income  Tax  Procedure,  i^2l,  pages  310-318. 


244  AUDITING— GENERAL  PRINCIPLES 

to  the  attorney.  It  often  happens  that  a  salesman  claims  com- 
missions in  excess  of  those  paid  to  him,  that  an  employee  who  has 
been  dismissed  claims  salary  or  other  compensation  for  an  uncom- 
pleted term  of  service,  or  that  claim  is  made  for  a  part  of  profits, 
which  has  not  been  paid.  It  is  true  that  these  are  unusual  items, 
but  it  is  equally  true  that  millions  of  dollars  have  been  paid  out  in 
liquidation  of  such  disputed  claims. 

If  an  auditor  finds  any  evidence  which  leads  him  to  suspect 
that  there  may  be  a  possible  liability  of  this  nature,  he  should 
insist  on  being  informed  as  to  all  of  the  facts.  He  can  then  form 
an  opinion  as  to  the  reserve,  if  any,  which  should  be  made  on  the 
books  and  balance  sheet  to  provide  therefor. 

Coupons,  Unused  Tickets,  etc. 

The  auditor  of  a  railway  company  expects  to  (but  may  not) 
find  a  reserve  account  for  the  outstanding  liability  on  unused 
tickets,  but  this  point  receives  little  or  no  attention  in  other  cases. 
Many  kinds  of  enterprises  sell  tickets,  or  issue  coupons  at  a  dis- 
coimt  for  cash,  which  are  a  charge  against  the  subsequent  oper- 
ation of  the  business.  Tickets  or  coupons  are  issued  by  taxicab 
companies,  spring-water  dealers,  restaurants,  amusement  parks, 
and  shows.  Telephone  companies  formerly  issued  stamps  good 
for  long-distance  calls. 

Not  all  of  the  unused  tickets,  etc.,  will  be  presented,  but  so 
long  as  they  are  outstanding,  provision  must  be  made  for  their 
redemption.  The  auditor  need  not  attempt  to  verify  the  out- 
standing liability  in  detail,  but  he  should  carefully  examine  the 
system  followed,  because,  if  the  proper  principles  are  observed,  the 
outstanding  book  liability  will  be  in  excess  of  the  actual  redemp- 
tion which  may  be  expected.  Many  tickets,  coupons,  etc.,  are  lost 
or  destroyed,  and  it  is  obviously  impossible  to  issue  duplicates. 

Deposits 

Reference  is  not  made  here  to  the  deposits  received  by  banks, 
bankers,  and  saving  funds,  but  to  the  funds  which  are  deposited 


BALANCE  SHEET  AUDIT— LIABILITIES  245 

as  a  guarantee  of  good  faith,  or  as  part  payment  on  a  purchase,  or 
as  security  for  an  unh'quidated  or  possible  debt. 

If  the  concern  operates  under  a  pubHc  franchise,  as  does  a  gas 
or  electric  company,  it  may  have  the  power  to  require  deposits,  and 
in  many  instances  it  will  be  charged  with  the  payment  of  interest 
thereon.  Interest  is  not  usually  paid  until  the  receipt  for  the 
original  deposit  is  surrendered,  and  this  may  be  many  years 
afterward.  Large  numbers  of  the  receipts  are  lost  or  destroyed 
and  demand  is  never  made.  Nevertheless,  the  companies  should 
carry  all  of  the  deposits  as  liabilities  and  reserve  the  interest 
accruing  thereon  until  a  sufficient  time  has  elapsed  to  warrant 
writing  off  such  deposits  as  may  remain  uncalled  for  so  long  that 
the  chances  of  pa5rment  are  remote. 

The  custom  of  receiving  deposits  of  money  from  employees 
is  well  enough  established  to  warrant  the  inclusion  of  the  caption 
''deposits"  as  one  of  the  liabilities  to  be  reported  by  prospective 
borrowers  to  banks. 

The  auditor  should  investigate  the  procedure  followed  from 
the  time  a  deposit  is  accepted  to  the  time  it  is  withdrawn.  There 
should  be  ample  safeguards  surrounding  the  handling  of  such 
funds,  since  the  deposits  are  frequently  offered  by  ignorant 
persons  and  foreigners  who  are  not  familiar  with  business  methods 
and  who  might  be  induced  to  accept  irregular  receipts  from  clerks 
not  authorized  to  handle  the  money.  It  is  important  that  the 
books  and  stationery  used  be  specially  prepared  for  the  purpose, 
and  the  utmost  care  should  be  taken  in  writing  up  the  records. 
The  clerk  in  charge  of  the  books  should  not  be  allowed  to  receive 
or  pay  money. 

If  pass-books  are  furnished  to  depositors,  the  auditor  should 
call  in  as  many  of  them  as  possible  and  compare  the  entries 
and  balances  with  the  books.  There  are  so  many  different 
methods  in  force  that  the  auditor  must  rely  on  his  general  experi- 
ence in  order  to  satisfy  himself  that  the  aggregate  deposits 
appearing  on  the  balance  sheet  as  a  liability  represent  the  actual 
amount  due  to  depositors.    The  rate  of  interest  paid  should  be 


246  AUDITING— GENERAL  PRINCIPLES 

verified  and  the  calculations  tested.  Accrued  interest  not 
credited  to  depositors  at  the  date  of  the  balance  sheet  should  be 
added  to  the  total  deposits  shown  by  the  books. 

For  various  methods  of  calculating  interest,  see  Chapter 
XXIX. 

In  clubs  and  similar  organizations  it  is  customary  for  members 
to  deposit  small  sums  as  security  against  the  loss  of  keys,  etc. 
To  avoid  bookkeeping  in  connection  therewith,  a  very  loose 
method  may  be  in  force.  Frequently  the  cash  received  is  placed 
in  a  drawer  or  box  without  any  record  being  made.  Subsequent 
payments  are  likewise  made  without  record.  Theoretically  the 
balances  on  hand  represent  the  liability  for  outstanding  keys,  etc. 
Practically  it  is  known  that  part  of  the  cash  will  never  be  called 
for.  This  permits  unauthorized  payments  to  be  made  from  the 
fund,  or  part  of  it  may  be  fraudulently  abstracted.  The  matter 
is  unimportant  except  that  such  laxity  places  temptation  in 
the  way  of  junior  clerks  and  may  be  responsible  for  starting  them 
on  a  criminal  career. 

The  auditor  should  call  attention  to  the  importance  of  making 
a  careful  record  of  all  receipts  and  payments,  no  matter  how 
small,  ostensibly  for  the  purpose  of  facilitating  an  audit,  but  in 
reality  to  inculcate  in  every  employee  handling  cash  the  greatest 
care  and  accuracy  in  connection  with  the  handling  of  money. 

Unclaimed  Dividends 

The  proper  way  of  dealing  with  dividend  accounts  is  to  set 
aside  in  a  separate  fund  or  bank  account  the  full  amount  of  each 
dividend  declared,  charging  against  it  all  pa)nnents. 

It  sometimes  happens  that  stockholders  cannot  be  reached, 
and  dividend  checks  are  withheld  or,  if  issued,  are  not  cashed 
within  a  reasonable  time.  This  may  leave  an  outstanding  lia- 
bility which  may  remain  undischarged  indefinitely.  If  such  a 
state  of  affairs  exists,  any  payments  out  of  the  regular  order 
should  be  noted,  since  it  may  be  found  that  unauthorized  pay- 
ments are  being  charged  thereto. 


CHAPTER  XIII 
BALANCE  SHEET  AUDIT— CONTINGENT  LIABILITIES 

A  balance  sheet  should  show  not  only  what  must  be  paid;  it 
should  show  all  contingent  debts  as  well.  Many  prosperous 
concerns  have  been  wrecked  because  compelled  to  meet 
obligations  which  did  not  arise  from  ordinary  business  trans- 
actions. Nevertheless,  the  obligations  were  real  ones,  no  matter 
how  unlike  real  ones  they  appeared  to  be  when  contracted,  and 
a  true  statement  of  the  financial  affairs  of  such  concerns,  prepared 
at  any  time  after  the  obligations  were  incurred,  would  have 
shown  them.  Accountants  experienced  in  bankruptcy  affairs 
well  know  that  rarely,  if  ever,  do  contingent  liabilities  appear 
on  the  books  of  account. 

It  is  the  duty  of  an  auditor  who  makes  a  balance  sheet  audit 
to  discover  and  report  upon  liabilities  of  every  description — not 
only  liquidated  debts,  but  contingent  debts  as  well.  It  is  true 
that  contingent  liabilities  are  at  best  difficult  to  locate,  and  almost 
impossible  to  discover  when  an  attempt  is  made  to  conceal  them, 
yet  a  professional  auditor  must  undertake  difficult  tasks,  and  if 
he  cannot  report  on  anything  except  the  entries  which  he  finds 
in  the  books,  he  should  retire  from  the  profession. 

Contingent  Liabilities  Defined 

As  used  in  a  balance  sheet  audit,  the  term  "contingent 
liabilities"  means:  (i)  primary  or  direct  financial  obligations 
which  at  the  date  of  the  balance  sheet  cannot  be  reduced  to 
stated  or  definite  amounts  and  for  which  specific  reserves  cannot 
reasonably  be  created,  and  (2)  secondary  financial  obligations 
upon  which  the  probable  loss,  if  any,  is  covered  by  adequate 
reserves.     As  pointed  out  elsewhere,  ^  balance  sheets  and  income 

^  Page  268. 

247 


248  AUDITING— GENERAL  PRINCIPLES    ' 

statements  are  always  based  upon  estimates.  The  auditor  must 
include  in  the  accounts  for  a  stated  period  all  of  the  income, 
charges,  and  losses  which  affect  that  period  even  though  many 
of  the  items  are  estimated.  The  term  "contingent  liabihties," 
therefore,  does  not  embrace  such  items  as  accrued  expenses 
and  losses  which  can  with  reasonable  accuracy  be  reduced  to 
figures. 

Primary  Obligations. — Class  (i)  includes  the  following: 
Litigated  matters,  such  as  alleged  patent,  copyright,  and  trade- 
mark infringements  and  damages  for  breach  of  contract,  and 
claims  which  are  founded  on  contracts  or  agreements  to  which 
there  appears  to  be  an  adequate  defense.  This  class  does  not 
include  damage  and  other  lawsuits  as  to  which  past  experience 
and  contractual  relations,  express  or  implied,  demand  that  reserves 
be  set  up  sufficient  to  charge  the  fiscal  periods  affected  with  all 
expenses  which  belong  thereto.  The  minutes  and  the  attorney 
for  the  concern  should  be  consulted  regarding  the  existence  of 
claims  of  this  nature. 

Secondary  Obligations. — Class  (2)  includes  secondary  or  in- 
direct obligations  as  to  which  no  liability  exists  unless  and  until 
the  primary  obligor  defaults.  When  the  principal  amount  of  the 
possible  liability  is  known  it  must  be  shown  in  the  balance  sheet.  ^ 
In  requesting  confirmations  from  bankers  of  direct  liabihties, 
request  should  also  be  made  for  a  report  of  indorsements,  guaran- 
tees, etc.  An  investigation  must  be  made  to  ascertain  the  prob- 
ability of  default  and  in  case  of  default  the  probable  loss,  if  any. 
When  it  appears  that  losses  will  be  sustained,  careful  estimates 
must  be  made  of  the  aggregate  and  entered  as  reserves  for  losses. 
The  debit  should  be  to  the  current  income  account  and  not  to  sur- 
plus.    Transactions  out  of  which  losses  may  occur  are  as  follows: 


*  It  is  customary  to  show  the  contingent  habilities  as  a  footnote  or  in  short 
in  the  body  of  the  balance  sheet.  However,  in  some  cases,  notably  notes  re- 
ceivable discounted,  it  is  good  practice  to  enter  the  liability  as  a  deduction 
from  the  notes  receivable  asset  items;  but  there  is  no  objection  to  stating  the 
amount  in  a  footnote.     For  balance  sheet  forms  see  page  367  et  seq. 


BALANCE  SHEET  AUDIT— LIABILITIES  249 

1.  Discount,  sale,  or  transfer  of  notes  receivable,  trade 

acceptances,  bank  acceptances  arising  under  com- 
mercial letters  of  credit,  domestic  and  foreign  drafts, 
such  as  those  drawn  by  automobile  manufacturers  upon 
their  dealers.  In  some  cases  sight  drafts  are  treated  as 
cash  deposits.  Any  unpaid  at  date  of  balance  sheet 
must  be  treated  as  accounts  receivable  discounted. 

2.  Indorsements    of    notes    for    affiliated    or    subsidiary 

concerns. 

3.  Indorsements  of  commercial  paper  as  accommodation 

party. 

4.  Selling,  pledging,  or  assigning  of  accounts  receivable 

where  the  transfer  attaches  a  contingent  liability  to 
the  seller,  pledger,  or  assignor. 

5.  The  opening  or  guaranteeing  of  letters  of  credit. 

6.  Guaranteeing  of  payment  of  interest  or  principal  of  the 

bonds  of  another  party. 

7.  Accepting  suretyships,  including  those  guaranteed  for 

others. 

8.  Contracts  for  purchase  of  foreign  exchange  for  future 

delivery. 

9.  Liability  for  unpaid  stock  subscriptions. 

In  all  of  the  foregoing  cases  the  contingent  liabilities  are  offset 
by  contingent  assets,  i.e.,  in  case  of  default  and  payment  by 
indorsers  or  guarantors,  accounts  or  debts  receivable  from  the 
latter  arise. 

In  addition  to  the  foregoing,  obligations  often  exist  which  are 
more  onerous  than  direct  liabilities,  viz.:  agreements  to  maintain 
certain  ratios  of  current  assets,  to  set  aside  reserves,  etc.  The 
various  obligations  mentioned  will  be  discussed  in  detail. 

Liabilities  Created  After  Date  of  Balance  Sheet 

In  many  cases  new  liabilities  are  created  between  the  dates 
of  balance  sheets  and  the  dates  when  audits  are  completed. 


250  AUDITING— GENERAL  PRINCIPLES 

Should  an  auditor  disclose  such  changes?  In  the  opinion  of  the 
author  it  is  not  proper  to  insist  on  showing  future  transactions 
on  a  balance  sheet  when  such  new  transactions  do  not  involve  any- 
accrued  profit  or  loss  at  the  date  of  the  balance  sheet.  When 
there  are  special  reasons  for  showing  future  transactions  on  a 
balance  sheet,  there  is  no  more  objection  to  the  practice  than  to 
any  pertinent  disclosure  of  possible  interest.  In  one  case  a 
mortgage  was  placed  by  a  corporation  on  its  plant  two  days  after 
the  date  of  its  annual  balance  sheet.  All  of  the  cash  proceeds 
from  the  sale  of  the  mortgage  were  used  for  additional  plant 
construction.  The  company's  net  current  asset  position  at  the 
date  of  the  balance  sheet  was  not  good;  even  so,  the  reasons  for 
not  mentioning  the  mortgage  were  stronger  than  the  reasons  for 
mentioning  it.  It  was  shown  that  the  mere  statement  that  a  new 
mortgage  was  created  would  have  an  unfavorable  effect.  To 
minimize  the  bad  effect  a  full  statement  of  the  manner  in  which 
the  proceeds  were  to  be  used  and  the  probable  increase  in  the 
earning  power  would  have  to  be  made;  such  a  discussion  is  not 
desirable  in  a  condensed  balance  sheet.  Those  who  are  directly 
interested  in  corporations  are  entitled  to  and  usually  receive  such 
information  promptly,  but  there  is  no  good  reason  for  incorpor- 
ating it  in  a  certified  balance  sheet. 

Notes  Receivable  Discounted 

As  shown  under  "Notes  Receivable,"^  an  apparent  asset 
may  result  in  an  actual  liability.  For  instance,  a  trade  debtor 
may  give  a  note  for  $i  ,000,  which  closes  his  account.  The  note  is 
discounted,  which  closes  the  notes  receivable  account.  The 
debtor  finds  he  cannot  pay  and  renews  the  note  when  due.  This 
may  be  repeated  several  times,  but  at  last  a  renewal  cannot  be 
secured  and  the  note  must  be  paid  by  the  indorser.  After  it  is 
known  that  the  note  will  not  be  paid  at  maturity  by  the  maker, 
the  liability  of  the  indorser  is  more  than  contingent — it  is  actual. 


3  Page  no. 


BALANCE  SHEET  AUDIT— LIABILITIES  25 1 

Offsetting  Reserves. — Of  course,  if  the  reserve  for  bad 
debts  includes  a  provision  for  the  full  amount  of  the  note,  it  is 
duplication  to  set  up  an  additional  reserve  or  create  a  liability 
against  the  payment  of  the  note.  Usually  the  bad  debts  reserve 
is  not  large  enough  to  take  care  of  the  contingent  liability  on 
notes  discounted,  so  that  the  auditor  should  investigate  the 
status  of  all  notes  under  discount,  and  if  it  appears  probable  that 
any  will  not  be  met  when  due,  the  liability  therefor  should  be 
shown.  If  the  auditor  is  satisfied  that  notes  will  neither  be  paid 
nor  renewed,  he  should  include  them  under  current  liabilities. 

Obligations  of  Subsidiaries. — In  the  case  of  a  large  hold- 
ing company  it  was  reported,  after  receivership  proceedings  had 
been  instituted,  that  while  its  published  reports  showed  liabilities 
of  several  millions  of  dollars,  there  existed  additional  liabilities 
aggregating  a  much  larger  sum.  Nominally  these  liabilities 
consisted  of  indorsements  upon  the  promissory  notes  received 
from  customers,  and  therefore  constituted  a  contingent  liability 
only.  Actually  the  notes  were  of  the  holding  company's  own 
manufacture,  being  the  nominal  obligations  of  subsidiary  cor- 
porations, and,  as  to  the  greater  part  they  were  not  represented 
by  assets.  In  other  words,  they  were  notes  payable  of  the  hold- 
ing company  without  offsetting  assets,  except  as  to  a  small  per- 
centage. The  notes  were  for  odd  dollars  and  cents,  presumably 
so  drawn  to  carry  out  the  fiction  of  being  genuine  receivables. 

Indorsements 

In  addition  to  the  contingent  liability  upon  notes  discounted 
for  the  benefit  of  the  indorser,  there  may  exist  a  liability  based  on 
indorsements  for  the  benefit  of  others.  These  are  usually  known 
as  accommodation  indorsements. 

It  is  not  proposed  to  discuss  this  subject  exhaustively,  since 
the  question  of  ultra  vires  at  once  arises,  but  from  a  practical 
point  of  view  it  may  be  assumed  that  every  indorsement,  whether 
by  an  individual,  firm,  or  corporation,  may  become  an  ultimate 


252  AUDITING— GENERAL  PRINCIPLES 

actual  liability  of  the  indorser.  Promissory  notes  are  negotiable 
instruments,  and,  in  order  that  they  may  circulate  freely,  an 
innocent  purchaser  for  value,  without  notice  of  a  lack  of  consider- 
ation on  the  part  of  a  maker  or  indorser,  may  sue  and  recover 
from  any  or  all,  in  turn. 

The  assumption  that  the  maker  will  pay,  or  that  the  notes 
will  not  be  used,  or  will  not  find  their  way  into  the  hands  of 
outsiders,  has  been  dissipated  in  so  many  thousands  of  cases 
that  the  auditor  who  fails  to  include  accommodation  indorse- 
ments as  liabilities  because  he  is  advised  that  there  is  no  possi- 
bility of  payment  being  demanded,  assumes  a  risk  for  which  there 
is  no  professional,  legal,  or  moral  justification. 

Why  Indorsements  Are  Secured. — It  is  possible  that 
circumstances  may  exist  in  which  such  indorsements  are  not 
liabilities,  as  when  a  note  is  overdue  and  the  holder  has  notice; 
but  the  vital  point  to  bear  in  mind  is  that  solvent,  straightforward 
concerns  as  a  rule  neither  request  nor  secure  indorsements  unless 
under  stress  of  necessity,  or  in  return  for  the  payment  of 
a  consideration.  If  the  maker  of  the  note  is  ''hard  up,"  the 
indorser  should  expect  to  pay  (as  he  usually  is  obliged  to  do). 
If  consideration  has  passed,  the  indorser  is  still  likely  to  have  to 
pay,  but  having  received  compensation,  his  statement  should 
show  the  amount  thereof  among  the  liabilities  to  indicate  the  risk 
which  has  been  assumed.  The  full  amount  of  the  note,  less  the 
compensation  received,  is  a  contingent  liability. 

Offsetting  Assets. — Naturally  the  auditor  should  not 
include  indorsements  among  the  liabilities  on  the  balance  sheet 
imless  he  gives  due  consideration  to  the  possibility  of  an  asset 
to  offset.  The  offset  usually  consists  of  a  claim  against  the 
maker  or  prior  indorser  who  has  failed  to  meet  an  obligation, 
which  is  at  once  prima  facie  evidence  that  the  asset  is  not  in 
satisfactory  shape.  In  the  majority  of  cases  it  is  merely  a 
question  of  sizing  up  a  bad  debt. 


BALANCE  SHEET  AUDIT— LIABILITIES  253 

Indorsements  Not  Apparent. — The  foregoing  remarks 
apply  to  cases  concerning  which  the  auditor  is  informed  or  can 
readily  ascertain  that  indorsements  are  outstanding.  We  have 
now  to  consider  the  procedure  where  such  information  is  neither 
volunteered,  nor  apparent  on  the  records.  The  author  was 
about  to  state  that  the  auditor  is  justified  in  assuming  that  the 
practice  does  not  exist,  since  most  concerns  have  a  strict  rule 
which  forbids  indorsements  or  guarantees,  and  that  there  must  be 
special  cause  for  suspicion  before  special  inquiry  need  be  made; 
but  reflection  brings  to  his  mind  so  many  instances  of  contingent 
liabilities  of  this  nature  that  the  suggestion  is  made  that  all  audit 
programs  contain  some  reference  thereto. 

Careless  Commitments. — The  financial  "atmosphere"  of 
a  concern  is  a  fairly  dependable  index  as  to  possible  obligations 
or  entanglements  which  may  find  expression  in  commitments 
leading  to  future  embarrassment.  The  most  common  cause  is 
overextension  of  business  affairs.  This  is  more  likely  to  occur 
with  a  prosperous  man  than  with  an  impecunious  one.  The 
latter  has  little  opportimity  for  expansion,  while  the  former  is 
fairly  besieged  by  promoters  and  others  who  know  by  long 
experience  that  the  most  likely  investor  in  a  new  and  untried 
enterprise  is  a  man  who  knows  nothing  at  all  about  it.  All 
over  the  country  men  who  have  made  fortunes  in  their  own 
businesses  are  squandering  their  capital  in  outside  ventures. 

If  an  auditor's  report  goes  no  farther  than  his  client's  office, 
it  is  nevertheless  necessary  for  him  to  concern  himself  with  the 
relation  of  outside  ventures  to  the  balance  sheet  of  the  business 
under  audit.  •  Now  that  banks  are  demanding  certified  balance 
sheets,  the  auditor  must  always  proceed  on  the  assumption  that 
the  balance  sheet  prepared  by  him  will  go  into  general  circulation. 
The  auditor  who  is  observant,  therefore,  is  able  to  determine 
from  what  he  sees  in  an  office  what  has  probably  taken  place 
outside. 

If  a  partner,  or  officer,  has  withdrawn  considerable  sums  of 


254  AUDITING—GENERAL  PRINCIPLES 

money  for  investment  in  outside  enterprises,  there  will  probably 
be  some  reference  thereto  in  the  books.  The  accounts  of  "  close  " 
corporations  (those  whose  stock  is  closely  held)  are  similar  to 
the  accounts  of  partnerships.  The  officers,  who  are  usually 
also  large  stockholders,  keep  personal  accounts  in  the  corporation 
books.  The  charges  to  these  accounts  indicate,  in  some  degree, 
the  interest  in  outside  affairs. 

Let  us  consider  the  usual  effect  on  the  finances  of  a  firm  or 
corporation  when  its  owners  are  connected  with  other  enterprises. 
The  firm  or  corporation  has  good  assets  of  $200,000  and  total 
liabilities  of  $100,000.  Suppose  one  or  more  of  the  partners  or 
officers  becomes  interested  in  another  business  or  in  a  flotation 
of  doubtful  merit.  It  may  be  urged  that,  so  long  as  the  balance 
sheet  of  the  firm  or  corporation  is  true  and  reflects  its  actual 
financial  condition,  the  action  of  its  partners  or  officers  cannot 
affect  it.  But  soon  the  outside  venture  requires  more  cash  than 
can  be  supplied,  so  the  partner  or  officer  gives  his  note  for  $25,000, 
which  is  discounted.  The  auditor  comes  in  at  this  point, 
discovers  the  interest  in  the  outside  deal,  makes  inquiry,  and  is 
informed  as  to  the  note.  He  finds,  furthermore,  that  there  is 
not  the  slightest  prospect  of  the  note  being  met  by  the  outside 
business. 

Is  it  not  apparent  that  the  cash  account  of  the  firm 
or  corporation  will  be  called  on  to  meet  that  note?  This  has 
happened  in  thousands  of  actual  cases;  is  it  not  liable  to  happen 
every  time?  Should  the  auditor  state  the  assets  at  $200,000, 
the  liabilities  at  $100,000,  and  a  contingent  liability  at  $25,000? 
Legally,  no;  but  if  he  can  find  a  way  to  do  it,  he  should  not  hesi- 
tate. Banks,  creditors,  and  investors  would  have  saved  millions  of 
dollars  in  the  past  if  auditors  had  so  stated  the  affairs  of 
corporations.  Is  it  not  possible  to  protect  the  innocent  investor 
or  creditor  when  facts  of  this  nature  are  disclosed,  and  when  a 
reasonable  interpretation  makes  them  relevant? 

If  there  is  nothing  in  the  books  to  indicate  any  connection  on 
the  part  of  the  concern  itself,  or  of  a  partner  or  an  officer,  with 


BALANCE  SHEET  AUDIT— LIABILITIES  255 

outside  ventures,  and  if  there  is  no  apparent  reason  for  suspecting 
any  possible  indorsement  of  another's  paper,  the  auditor  may 
not  feel  it  necessary  to  carry  his  inquiries  further.  In  fact,  it 
may  be  impracticable  even  if  it  were  desirable.  Nevertheless,  it 
must  always  be  borne  in  mind  that  the  indorsement  of  notes  for 
outside  ventures  has  resulted  disastrously  in  cases  where  it  was 
least  expected;  consequently  it  is  a  possibility  of  importance. 

Guarantees,  Suretyship 

Almost  all  of  the  remarks  under  "Indorsements"  apply  with 
equal  force  to  guarantees.  In  one  case  the  liability  is  fixed  and 
definite  by  reason  of  the  indorsements  of  negotiable  paper, 
whereas  a  guarantee  may  be  less  definite  so  far  as  legal  hability  is 
concerned,  and  the  amount  of  the  obligation  may  be  uncertain. 
Otherwise  there  is  the  same  likelihood  of  being  required  to  pay 
ultimately,  and  if  the  guarantee  covers  an  obligation  incurred  in 
connection  with  an  outside  venture,  there  also  exists  a  strong 
probability  that  the  funds  necessary  to  discharge  the  obligation 
will  be  withdrawn  from  the  concern  under  audit. 

An  Illustration. — The  proprietor  of  a  successful  business 
reported  to  the  mercantile  agencies  a  net  worth  of  about  one 
million  dollars.  His  statement  indicated  that  his  assets  were 
not  readily  realizable,  but  his  reported  liabilities  were  small  and 
his  credit  was  rated  first  class.  He  was  induced  to  invest  in  the 
stock  of  a  distillery  and  was  elected  a  director.  The  distillery 
needed  money  and  he  was  induced  to  indorse  some  of  its  paper 
and  guarantee  other  loans. 

The  president  of  the  distilling  company  was  found  to  be 
an  embezzler  to  a  large  amount,  and  the  company  went  into 
bankruptcy.  The  indorser  and  guarantor  was  called  upon  to 
meet  obligations  aggregating  over  $100,000,  and  he  was  unable 
to  pay  all  of  his  debts  as  they  became  due.  He  eventually 
compromised  with  his  crediters  at  50  cents  on  the  dollar. 

If  an  auditor  had  stated  the  accounts  of  the  guarantor's 


256  AUDITING— GENERAL  PRINCIPLES 

business  it  is  not  likely  that  any  mention  would  have  been  made 
of  the  outside  liabilities,  since  the  business  was  incorporated  and 
the  indorsements  would  have  been  ultra  vires  for  the  corporation. 
But  when  the  notes  came  due  and  the  guarantor  started  to  pay, 
the  only  fimds  available  were  the  resources  of  his  own  company, 
and  these  funds  were  used.  Therefore  his  balance  sheet  handed 
to  the  agencies  was  misleading,  because  there  were  contingent 
liabilities  affecting  it  in  fact  if  not  in  law. 

An  auditor  could  have  readily  ascertained  the  existence  of 
the  directorship,  and  inquiry  no  doubt  would  have  brought  to 
light  the  indorsements  and  guarantees.  If  so,  would  he  have 
been  justified  in  mentioning  the  matter  on  the  balance  sheet? 
The  author  is  of  the  opinion  that  it  would  have  been  desirable 
for  him  to  do  so.  Whether  or  not  it  would  have  been  his  clear 
duty  could  have  been  determined  only  in  connection  with  the 
circumstances  of  his  employment.  In  a  serious  matter  of  this 
nature  an  auditor  should  consult  his  attorney  before  disclosing 
damaging  information,  because  it  is  possible  that  the  scope  of  his 
employment  may  be  limited  and  that  his  only  course  is  to  with- 
draw from  the  engagement. 

Acceptances 

An  acceptance  is  a  draft  or  bill  of  exchange,  across  the  face  of 
which  are  written  ''accepted"  and  the  date  thereof,  and  ''pay- 
able" and  the  date  thereof,  after  which  appears  the  signature  of 
the  payee.  When  the  acceptor  is  not  a  bank  or  banker,  the  name 
of  the  bank  or  the  place  at  which  the  acceptance  is  payable  is  also 
inserted. 

Increasing  Use  of  Acceptances. — The  use  of  acceptances 
in  this  country  has  greatly  increased  in  recent  years.  Since  the 
Federal  Reserve  Act  authorized  member  banks  to  accept  bills 
involving  the  exportation  or  importation  of  goods,  interest  in 
and  the  use  of  acceptances  have  greatly  increased.  In  the 
state  of  New  York,  state  banks  and  trust  companies  are  permitted 


BALANCE  SHEET  AUDIT— LIABILITIES  257 

to  accept  drafts  drawn  upon  them  by  their  customers  at  sight, 
or  on  time  not  exceeding  one  year.  This  power  extends  to  both 
foreign  and  domestic  trade. 

Advantages  of  Acceptances. — Constructive  service  can  be 
rendered  by  auditors  by  pointing  out  to  their  clients  the  advan- 
tages of  a  greater  use  of  domestic  acceptances.  Concerns  which 
are  not  adequately  financed  frequently  borrow  money  on  their 
accounts  receivable,  although  the  practice  is  not  favorably 
regarded  by  bankers  and  credit  men.  The  cost  of  capital  thus 
secured  is  at  least  double  the  usual  rate  charged  on  bank  dis- 
counts. If  purchasers  agree  to  accept  drafts  drawn  upon  them, 
covering  specific  invoices  payable  on  the  due  dates  thereof,  there 
is  then  available  to  the  sellers  negotiable  paper  which  can  be 
discounted  at  a  favorable  rate.  This  plan  has  material  advan- 
tages, is  a  saving  to  the  seller,  and  involves  the  purchaser  in  no 
more  annoyance  than  is  necessary  in  drawing  and  sending  cheques 
under  the  present  system.  The  Federal  Reserve  Board  strongly 
encourages  this  custom,  and  it  may  be  expected  that  suitable 
legislation  will  be  enacted  from  time  to  time  which  will  make  it 
even  more  desirable  than  it  now  appears. 

Treatment. — Since  financing  by  acceptances  is  becoming 
more  popular,  the  auditor  should  be  prepared  to  advise  as  to  the 
proper  treatment  of  the  liability  arising  out  of  their  issuance  or 
acceptance.  A  concern  drawing  a  draft  on  a  customer,  which  is 
accepted  by  a  bank  or  banker,  can  immediately  discount  it  at  its 
own  bank  or  sell  it  in  the  open  market,  usually  at  a  rate  under 
the  discount  rate  for  commercial  paper.  From  the  point  of  view 
of  the  drawer,  the  transaction  is  then  closed  and  no  mention  need 
be  made  thereof  on  his  balance  sheet.  Of  course  this  rule  applies 
only  when  the  accepting  bank  or  banker  is  of  unquestioned  stand- 
ing. If  the  drawee  does  not  have  national  standing,  consideration 
must  be  given  to  the  contingent  liabiHty  existing  until  the  draft 
is  paid  by  the  acceptor  or  customer.  The  transaction,  therefore, 
is  of  the  nature  of  a  customer's  promissory  note  discounted  at 


258  AUDITING— GENERAL  PRINCIPLES 

bank,  and  the  book  entries  are  the  same,  except  that  notes  not 
paid  at  maturity  must  be  kept  track  of  and  preparation  made 
to  meet  them,  whereas  the  accepting  bank,  in  the  case  of  an 
acceptance,  is  responsible  for  the  payment. 

Unrecorded  Liabilities. — It  is  the  relation  between  the 
bank  and  the  concern  for  which  it  is  accepting  that  requires 
vigilance  on  the  part  of  the  auditor.  The  issuance  of  promissory 
notes  and  the  liability  for  the  payment  thereof  is  fully  covered 
elsewhere  in  this  book."*  Consideration  must  now  be  given  to 
the  possibility  of  an  outstanding  liability  on  acceptances  not 
recorded  upon  the  books. 

Is  it  possible,  however,  for  a  concern  to  purchase  goods, 
arrange  to  have  a  bank  accept  the  vendor's  draft,  and  receive 
and  put  the  goods  in  stock,  and  yet  make  no  record  of  the  existing 
liability  until  the  due  date  arrives? 

So  many  instances  are  known  in  which  goods  were  received 
and  the  invoices  were  not  duly  recorded,  that  equal  attention 
must  be  given  to  this  possibiHty  when  acceptances  are  concerned. 
The  usual  comparison  of  order  and  receiving  records  with  pur- 
chase invoices  should  disclose  any  discrepancies  arising  from  care- 
lessness. It  is  not  likely,  however,  that  the  additional  safeguard 
of  a  comparison  of  creditors'  statements  with  corresponding 
ledger  accounts  will  be  feasible,  because  an  acceptance  usually 
covers  specific  invoices  and  it  is  not  likely  that  after  the  receipt 
of  an  acceptance  the  creditor  will  continue  to  include  the  invoices 
covered  thereby  in  statements  even  though  the  invoices  represented 
by  acceptances  are  in  fact  still  unpaid.  Banks  make  a  charge  for 
services  in  accepting  drafts,  and  payments  of  these  charges  should 
be  vouched  in  connection  with  the  acceptances  recorded. 

Where  there  is  any  likelihood  of  acceptances  being  outstand- 
ing, the  auditor  should  ask  the  bank  or  banks  connected  with  the 
concern  under  audit  to  confirm  the  existence  or  non-existence  of 
such  possible  liability. 

4  See  page  233. 


BALANCE  SHEET  AUDIT— LIABILITIES  259 

Bank  Audits. — The  audit  of  a  bank  or  banker  necessarily 
involves  consideration  of  the  contingent  HabiHty  which  exists, 
so  long  as  funds  are  not  provided  to  meet  at  maturity  the  accept- 
ances which  are  outstanding.  Here,  too,  there  is  a  direct  relation 
between  the  charges  for  accepting  and  the  acceptances  matured 
and  unmatured.  The  best  method  of  exhibiting  the  liability 
on  the  books  of  the  bank  or  banker  is  to  debit  the  customer  for 
whom  the  indorsement  is  made  and  credit  bills  payable.  As 
the  dates  of  maturities  arrive  it  is  expected  that  funds  will  be 
received  to  meet  the  payments  due,  thus  closing  the  customer's 
account;  and  the  payment  of  the  acceptances  as  presented  in  due 
course  will  close  the  bills  payable  account. 

Capital  Stock  Convertible  into  Bonds 

Some  issues  of  preferred  stocks  are  convertible  into  bonds  or 
other  obligations,  under  conditions  specified  in  the  agreements 
under  which  they  are  issued.  Until  there  is  actual  conversion, 
there  is  no  corporate  liabihty.  In  all  cases  balance  sheets  should 
show  the  terms  of  conversion.  When  conversion  in  substantial 
amount  has  taken  place  between  the  date  of  the  balance  sheet 
and  the  date  of  the  auditor's  certificate,  attention  should  be 
called  thereto. 

Unfulfilled  Contracts 

We  have  said  that  liabilities,  not  shown  on  the  books,  in  the 
form  of  contracts  to  accept  delivery  of  goods  contracted  for 
before  the  date  of  the  balance  sheet,  may  call  for  the  payment  of 
large  sums  of  money  within  a  short  space  of  time.  It  may  be 
urged  that  on  the  face  of  this  statement  there  is  no  change  in  the 
net  result  shown  by  the  balance  sheet,  since  an  asset  is  received 
to  offset  the  liability. 

Orders  for  Future  Delivery. — A  banker,  however,  may 
look  upon  this  condition  in  a  far  different  light.  The  balance 
sheet,  for  instance,  may  show  stock  on  hand  large  enough  or  too 


26o  AUDITING—GENERAL  PRINCIPLES 

large  for  the  normal  requirements  of  the  business.  Unfulfilled 
contracts  outstanding  at  the  date  of  the  balance  sheet  which 
call  for  the  receipt  of  additional  stock,  which  may  not  be  readily 
salable,  will  result  in  an  actual  liability,  whereas  the  offset,  the 
stock  to  arrive,  will  be  an  asset  of  doubtful  value. 

In  every  audit,  therefore,  the  auditor  should  call  for  copies  of 
all  orders  for  future  delivery.  If  such  orders  call  for  stock  in 
excess  of  the  current  and  reasonable  prospective  demand,  men- 
tion thereof  should  be  made  in  the  balance  sheet.  The  details 
reported  should  depend  on  the  circumstances  of  each  particular 
case. 

On  December  31,  1920,  many  concerns  had  outstanding 
commitments  to  receive  goods  and  materials  and  to  pay  therefor 
much  higher  prices  than  similar  goods  could  be  secured  for  at  that 
time.  In  so  far  as  conditions  were  obviously  considered  to  be 
temporary,  the  apparent  loss  was  not  taken  up  by  most  concerns 
in  their  accounts  at  December  31.  Part  of  the  responsibility 
for  failure  to  recognize  a  material  factor  was  due  to  the  United 
States  Treasury  Department  which  promulgated  a  rule  that 
inventories  could  not  include  goods  the  title  to  which  had  not 
passed  to  the  purchaser. 

Treatment  of  Contracts  for  Future  Delivery. — The 
question  of  possible  losses  arising  from  future  contracts  must  be 
settled  without  regard  to  the  tax  situation.  A  concern,  at  De- 
cember 3 1 ,  1920,  had  contracted  for  the  delivery  of  200,000 pounds 
of  crude  rubber  at  40  cents  a  pound,  of  which  100,000  pounds  had 
been  received  or  was  in  transit  and  the  remainder  had  not  been 
shipped.  Other  concerns  were  similarly  situated.  The  market 
price  on  December  31,  1920,  was  20  cents  a  pound,  but  there  were 
few  purchases  at  that  price  even  though  the  cost  of  production 
was  nearer  30  cents  than  20  cents  a  pound.  Does  good  account- 
ing practice  demand  uniform  practice  in  dealing  with  the 
situation? 

What  actually  happened  was  this: 


BALANCE  SHEET  AUDIT— LIABILITIES  261 

1.  Concern  A  inventoried  the  rubber  on  hand  and  in  transit 

at  30  cents  a  pound  and  made  no  provision  for  the 
quantity  undelivered,  under  the  theory  that  20  cents  a 
pound  was  not  a  fair  market  price,  and  that  good 
accounting  practice  does  not  require  the  taking  up  of  a 
prospective  future  loss. 

2.  Concern  B  inventoried  the  rubber  on  hand  and  in  transit 

at  20  cents  a  pound,  under  the  rule  ^'cost  or  market, 
whichever  is  lower,"  and  made  no  provision  for  the 
undelivered  rubber. 

3.  Concern  C  inventoried  the  rubber  on  hand  and  in  transit 

at  20  cents  a  pound,  and  out  of  surplus  set  up  a  reserve 
to  write  down  to  20  cents  a  pound  the  rubber  to  arrive. 

4.  Concern  D  inventoried  all  rubber  on  hand  and  con- 

tracted for  at  20  cents  a  pound. 

5.  Concern  E  inventoried  the  rubber  on  hand  and  in  transit 

at  cost  (40  cents  a  pound)  under  the  theory  that  the 
nominal  market  price  was  considerably  under  cost  of 
production  and  that  40  cents  a  pound  represented  a 
great  decline  from  the  war  prices  and  was  less  than  the 
pre-war  price. 

6.  Concern  F,  prior  to  December  31,  canceled  all  of  its 

contracts  and  set  up  as  a  definite  liability  the  amount 
due  the  vendors  as  damages. 

It  has  been  urged  that  the  orders  in  hand  for  manufactured 
goods  influence  the  basis  of  valuation  of  raw  materials;  that  if 
goods  are  to  be  delivered  to  responsible  customers  at  prices  fixed 
with  regard  to  40-cent  rubber,  the  writing  down  of  the  value 
of  the  raw  material  would  unduly  decrease  the  1920  profits  and 
unduly  increase  the  192 1  profits.  From  the  point  of  view  of  a 
going  concern,  this  argument  is  entitled  to  great  weight.  It  has 
the  merit  of  being  definite.  It  has  two  weaknesses,  however 
viz.,  first,  the  probability  of  cancellations  of  orders  by  solvent 
concerns  and  the  prevalent  custom  of  accepting  cancellations 


262  AUDITING— GENTERAL  PRINCIPLES 

without  penalty;  secxMid.  if  it  devd<^  that  the  dedine  in  raw 
mateiiak  is  pennanent  or  if  farther  dedines  take  place,  it  may  be 
oonsidcfed  to  be  good  bosiiiess  policy  to  accept  cancdlations  or 
to  reduce  saks  prices.  In  either  of  these  contingencies  there 
would  be  no  undue  increase  in  1921  profits  arising  frmn  a  drastic 
writing  down  oi  inventories. 

In  theory,  the  best  practice  is  to  write  down  all  inventories, 
induding  goods  to  arrive,  to  market  prices.  But  the  author 
does  not  advocate  this  practice  unless  the  so-called  maiket  prices 
are  reasonably  stable.  The  result  is  not  accomplished  by  setting 
iq>  a  reserve  for  possiMe  loss  out  oi  general  surj^us.  Wliatever 
aiTomifehes  the  best  result  is  the  best  practice.  A  true  picture 
is  to  be  painted  if  posaMe.  The  greatest  objection  to  setting  iq> 
contingency  reserves  out  of  general  surplus  is  that  charges  against 
SDch  reserves  do  not  appear  at  any  time  as  charges  against  income. 
In  making  comparisons  for  investment  and  other  purposes  over  a 
period  <rf  years,  what  is  designated  as  net  earnings,  or  net  inoxne, 
or  net  profits,  is  used. 

If  it  is  believed  that  a  pennanent  decline  has  taken  {^ace, 
the  amount  written  down  belongs  in  the  income  account.  If  the 
dedine  is  believed  to  be  tenqxxrary,  it  obscures  the  picture  to 
meicly  segregite  part  of  sari^os.  It  is  better  to  state  that  the 
entile  smphis  is  availaUe  for  extracxdinary  charges. 

TuF.ATifFvr  IX  Baiaxce  Sheet. — ^It  is  not  general  practice 
to  show  in  certified  balance  sheets  future  commitmoits — sales  or 
purchases;  until  it  becomes  fairiy  general  it  cannot  be  cmsideied 
good  acooonting  practice  to  inast  upon  it,  hat  Tt^KmtBerihe  ifif or-- 
wutHamisessemHalioa  imtjmamcial  fiositiom,  it  must  be  done.  The 
informatiofi  conveyed  is  oi  great  interest  and,  unless  publication 
discioses  trade  secrets,  the  practke  started  to  some  extent  ascrf  De- 
cember 31, 1920,  should  be  encouraged.  When  it  is  deemed  iHoper 
to  disHose  the  infonnation,  the  following  fonns  are  suggested:^ 


'From  "Xfcatment  of  fyuMMftiitfHfy  oi  Ihifducefs,"  by  Homer  fi, 
SmteU  Jmwmi  €§  AawmwUmy,  Mardi,  1921,  pages  169, 170,  and  172, 


BALAXCS  SHEET  AUDIT— UAHUTIBS 


fM  (dttte  off  UboKs  sfaecD  i«p«Citad  S. 

(pcnodid 


CpcriodofftiiM^wrtitiMBi^at 

$ or$ MwrethMitfceMMAeft^raiiicqfftlicMlmrikat: 

(even  date  or  sore  icccaft  dOc^ 


Oft  Ok  Insisoff  MukcftTdhnaft  (dttteoff  1 


Tke  ooiVuqF^  oa^taMOls  lor  psKlMe  off 

(pciiod  off  tiii^  oslsludfaig  at  Cattle  off  fcolun  dhecO 

$ orS ■MmtkanaieaufcetirdheofftkeBEitciakotfevai 

date  ormre  iwesl  daeK  iMift  $. 
iii«$ astkei 

Tie  oaf  JBIi  il  p«aBse  coiitnicis  ^WMprte  $ at(drteoff 

aace  slwet),  aad  aHer  nfiijia^  teicfta  Hk 

csccssoff  tkeiBYCitaiy  at  (dUeofflnluKesfcMtl 

off  MirtLct  Taloes  at  (due  off  lNla«De  shtet  or  sflR  looeit  daft^  a  < 

fcat  kes  off  appwynmatehr  $. 


Bond^  If otoi  iDttd  Ptttomd.  Slide 

Neufy  an  lymntnts  eaterod  into  by 
tiidr  securities  to  tlie  pnblk  cotttaia  SHM^ 
tlie  mawitefymoe  of  adeqaite  act  onnniiit  assets.    TIkk 
piovisioiis  irfiidi  are  ooninMNa  to  aft  sack  apccneals  aad 
are  ^lecni  fnovisiQiis  In  ahnc^  evwr  agaoaijMt    Aa 
off  some  oC  tke  pioviskHts  contained  ia  a  cafeM^  dmm 
moit  wili  be  found  ia  Appeiwfer  E. 

Faihue  to  obsiorve  the  st^MdatioBs  k  diagifmri  becawae  de- 
fault may  autonatkadly  tiaasfona  loiagteim  MJaKties  «te  car- 
rent liabflitte and autiioriaekig  anaMMnMitM  eaqpMrfitMesl6r  Ae 
ptotection  of  creditois. 

In  aU  cases  cifiies  of  ^be  acreeEwats  aaikst  be  secured  and  R^ 
Any  substantial  variance  f  lom  ^be  tenas  UMSt  be 
tbc  balance  dwel. 


264  AUDITING— GENERAL  PRINCIPLES 

The  Minute  Book 

Experience  has  shown  that  the  minute  book  is  a  very  prolific 
source  of  information  as  to  contingent  Habilities.  About  ten 
years  ago,  for  several  years  in  succession  one  of  the  largest  corpor- 
ations in  this  country  issued  its  annual  reports,  containing  an 
auditor's  certificate  which  said  in  effect:  ''The  balance  sheet  is 
correct,  subject  to  any  adjustments  which  may  be  indicated  by 
the  minute  books,  which  we  were  requested  not  to  read."  The 
practice  must  have  aroused  adverse  comment  since  subsequent 
certificates  were  unqualified. 

If  the  minute  books  contained  evidence  of  liabiHties  or  of 
changes  in  assets,  as  might  be  inferred  from  the  refusal  to  submit 
same  to  the  auditors,  how  much  dependence  can  the  directors 
expect  to  have  placed  upon  their  report  by  the  stockholders  and 
the  pubUc?  On  the  other  hand,  if  the  contents  of  the  minute 
books  are  harmless,  why  should  the  auditors  be  refused  access 
thereto,  thus  giving  rise  to  unfavorable  comment? 

The  auditor  should  always  insist  on  an  inspection  of  the 
minutes  of  the  board  of  directors,  also  of  the  executive,  or  any 
other  committee  of  the  board.  If  permission  is  withheld,  his 
certificate  should  be  written  along  the  lines  indicated  above, 
except  that  such  refusal  is  notice  to  the  auditor  that  special  care 
should  be  taken  in  passing  upon  balance  sheet  items  which  may 
be  affected  by  the  action  of  a  board  of  directors. 

Points  Involved. — ^The  following  points  may  be  involved: 
contracts  for  additions  to,  or  for  additional,  plant  equipment; 
purchase  of  other  corporations  or  large  interests  therein;  con- 
tracts for  future  dehveries  of  goods  and  materials  in  unusual 
quantities;  payments  of  bonuses  and  special  compensation  to 
officers  and  others  out  of  past  profits,  actual  payment  to  be  made 
at  a  future  date;  settlement  of  pending  litigation  and  disputes 
regarding  tax  and  similar  obligations,  for  sums  in  excess  of  the 
liability,  if  any,  carried  therefor  in  the  books;  possibility  of 
litigation,  such  as  alleged  infringement  of  patents,  which  might 


BALANCE  SHEET  AUDIT— LIABILITIES  265 

seriously  affect  the  value  of  assets;  contracts  or  agreements  which 
might  tend  to  increase  the  assets  or  reduce  the  liabihties.  These 
are  only  a  few  of  the  matters  which  a  reading  of  corporate  minutes 
reveals  to  the  auditor. 

Illustrations. — Usually  there  is  a  disposition  to  conceal 
from  an  auditor  evidence  of  contingent  liabilities,  the  thought 
being  that  he  may  feel  it  his  duty  to  provide  therefor  in  the  balance 
sheet.  Less  frequently,  good  news  is  withheld  in  order  that  the 
balance  sheet  will  appear  as  badly  as  possible  and  thus  give  the 
directors  time  to  acquire  stock  below  its  value. 

The  author  once  insisted  on  reading  the  minute  book  of  a 
street  railway  company.  The  president's  reluctance  to  produce 
the  book  w^as  explained  when  it  was  found  that,  at  a  meeting 
which  the  president  attended,  he  had  agreed  to  accept  common 
stock  of  the  company  at  par  for  his  services.  He,  however, 
directed  the  treasurer  to  pay  him  in  cash.  Since  the  stock  was 
worth  only  a  few  dollars  a  share,  his  disinclination  to  carry  out 
his  agreement  was  natural,  perhaps,  but  illegal  and  dishonest. 
He  was  obliged  to  adjust  the  matter. 

If  an  officer  of  a  corporation  is  found  to  be  interested  as  a 
partner  or  otherwise  in  an  outside  enterprise  with  which  the 
corporation  has  business  relations,  the  connection  should  be 
carefully  noted  and  it  should  be  ascertained  whether  authorized 
by  the  board  of  directors.  If  not  so  authorized,  the  directors 
should  be  required  to  take  some  formal  action  in  order  to  avoid 
possible  subsequent  criticism.  The  officer,  for  his  own  protection, 
should  welcome  such  a  course;  but  if  he  does  not,  the  auditor 
himself  should  bring  the  matter  to  the  attention  of  the  board. 

The  author,  while  auditing  the  accounts  of  a  chain  store 
company,  found  that  the  treasurer  of  the  company  was  interested 
in  a  concern  supplying  the  fixtures  to  the  various  stores  owned. 
The  price  of  the  fixtures  seemed  extremely  high  and  the  chain 
store  company  was  very  unsuccessful.  The  coincidence  seemed 
important  enough  to  wa;rrant  mention  of  it  in  the  report.    The 


266  AUDITING— GENERAL  PRINCIPLES 

directors,  however,  sustained  the  treasurer  and  removed  the 
auditor.  Since  the  board  had  theretofore  authorized  the  capi- 
tahzation  of  a  lease  and  the  writing  up  of  another  item 
equally  reprehensible,  crediting  both  fictitious  items  to  surplus 
and  using  the  entire  surplus  for  dividends,  the  auditor,  being  on 
record  as  to  all  of  the  questionable  transactions,  cheerfully 
retired  without  any  effort  to  defend  his  position.  Two  years 
later  the  company  went  into  bankruptcy. 

In  a  New  Jersey  receivership  proceeding,  it  developed  that 
the  minutes  of  the  board  of  directors  contained  much  information 
relative  to  finances  and  operations  which  had  not  been  disclosed 
to  the  stockholders  in  the  annual  statement.  The  company  had 
not  employed  professional  auditors.  These  illustrations  show 
the  importance  of  the  examination  of  the  minute  book. 


CHAPTER  XIV 

BALANCE  SHEET  AUDIT— RESERVES,  CAPITAL, 
AND  SURPLUS 

RESERVES 

The  status  of  reserve  accounts  is  unsatisfactory  from  the 
point  of  view  of  the  professional  auditor,  chiefly  because  the 
term  *' reserve"  is  indiscriminately  applied  to  items  which  are 
essentially  different.  Thus  an  inspection  of  balance  sheets  dis- 
closes that  the  following  accounts  are  called  ''reserves " :  provision 
for  probable  losses  on  accounts  or  notes  receivable;  accounts  set 
up  to  cover  depreciation  of  plant  and  other  assets  such  as  pat- 
ents, trade-marks,  etc.;  discounts  which  it  is  expected  will  be 
deducted  by  trade  debtors;  arbitrary  charges  against  surplus  to 
provide  a  book  account  for  ''working  capital";  sinking  fund  ac- 
counts to  take  care  of  depletion  of  mines,  or  to  retire  bonds  at 
maturity. 

Two  Classes  of  Reserves. — It  should  be  noted  that  some 
so-called  reserves  are  really  deductions  from  assets  and  should  be 
so  treated.  These  have  the  effect  of  liabiHties,  but  other  reserves 
are  not  HabiHties  at  all.  The  distinction  lies  in  the  purpose  for 
which  the  account  is  created.  If  the  debit  or  offsetting  entries 
are  proper  charges  against  income,  then  the  accounts  should  be 
deducted  from  the  assets  to  which  they  relate,  or  else  they  should 
be  set  up  as  liabilities  and  should  never  be  grouped  with  the 
surplus  accountj  On  the  other  hand,  if  the  accounts  (such  as 
the  last  two  mentioned  above)  represent  sums  set  aside  after  the 
net  income  of  an  enterprise  is  properly  determined,  to  conserve 
its  financial  interests  by  reducing  the  surplus  available  for 
dividends,  these  sums  in  reality  form  part  of  the  general  surplus 

267 


268  AUDITING— GENERAL  PRINCIPLES 

of   the   business.     In   preparing   balance   sheets,    these   latter 
accounts  should  be  stated  as  a  section  of  the  surplus  account. 

Surplus  Reserves. — Reserves  for  retirement  of  bonds,  notes, 
or  preferred  stock,  for  working  capital  and  for  contingencies  are 
examples  of  surplus  reserves.  The  chief  purpose  and  value  of 
such  reserves  is  to  prevent  the  payment  of  dividends  until 
certain  obligations  are  met,  after  which  the  reserves  should  be 
transferred  back  to  surplus  unless  it  is  not  proper  to  do  so.  ^  If 
there  is  no  reasonable  chance  that  reserves  will  be  restored  to 
surplus,  it  is  plain  that  the  reserves  were  improperly  created — 
they  should  have  been  debited  to  income  instead  of  to  surplus  in 
the  first  instance. 

Net  Income. — The  accountant's  definition  of  net  income, 
which  has  been  upheld  by  the  courts,  "^  requires  charges  against 
income  for  all  expenses  and  losses  accrued  as  well  as  paid  during 
a  certain  period.  The  main  difference  between  the  decisions  of 
the  courts  and  good  accounting  practice  is  that  the  courts  uphold 
the  principle  that  when  so-called  gross  income  is  indeterminate 
or  doubtful  it  must  be  appraised  at  its  net  value,  or  entirely 
omitted  from  a  computation  of  net  income  until  the  outcome  is 
definitely  ascertained,  whereas  accountants  include  the  items  in 
full  in  gross  income  and  appraise  the  net  value  at  the  end  of 
accounting  periods  by  means  of  reserves.  The  net  result  is  the 
same,  viz.,  the  net  income  for  each  period  is  stated  on  the  most 
accurate  basis  possible.  Of  course  in  such  computations  there 
is  much  estimating  but  it  is  careful  estimates  which  make  for 
accuracy.  All  balance  sheets  and  income  statements  are  based 
to  some  extent  on  estimates.  Inaccurate  balance  sheets  and 
income  statements  are  those  in  which  the  least  care  is  given  to 
estimates.  Accurate  balance  sheets  and  income  statements  are 
based  upon  careful  estimates. 

The  Treasury  in  the  past  has  adopted  a  method  of  ascertain- 


'  See  page  283. 
*  See  page  30&. 


BALANCE  SHEET  AUDIT— RESERVES  269 

ing  net  income  which  ignores  both  court  decisions  and  good 
accounting  practice.  Its  method  permits  full  inclusion  of  esti- 
mates which  are  extremely  difficult  to  compute,  such  as 
depreciation  and  obsolescence,  but  excludes  estimates  which  can 
be  determined  with  much  less  difficulty,  such  as  bad  debts. 
Eventually  net  income  as  defined  in  income  tax  practice  will  agree 
with  net  income  as  defined  by  the  courts  and  as  reflected  in 
good  accounting  practice.  In  the  meantime  the  latter  must  not 
be  departed  from  to  correspond  with  certain  Treasury  regulations 
which,  in  the  author's  opinion,  are  erroneous.  ^ 

Duty  of  Auditor. — The  auditor's  duty  is  to  segregate  the 
accounts  so  that  the  distinction  in  a  balance  sheet  between 
liabilities  and  net  worth  will  be  apparent  at  a  glance.  It  should 
not  be  necessary  to  make  elaborate  calculations  to  arrive  at 
capital  and  surplus. 

Reserves  such  as  those  set  up  to  provide  additional  working 
capital  cannot  be  treated  as  a  liability  in  any  sense.  To  whom  is 
it  to  be  paid?  From  a  balance  sheet  point  of  view,  a  liabihty 
is  an  obligation  or  a  debt  to  the  public,  i.e.,  something  which 
must  or  may  have  to  be  paid  before  partners  or  stockholders  can 
receive  a  dividend  or  a  distribution. 

Treatment  on  Balance  Sheet. — In  actual  practice  reserves 
are  usually  shown  in  the  balance  sheet  between  the  definite 
liabihties  and  the  surplus,  making  it  possible  to  show  the  aggre- 
gate of  the  two  classes  and  thus  arrive  at  the  proper  amount  to 
be  deducted  from  the  total  assets  in  arriving  at  net  worth. 
Whenever  possible  the  reserves  should  be  deducted  from  the 
assets  to  which  they  relate;  but  if  there  are  good  reasons  for 
stating  the  gross  amount  of  the  assets  on  one  side  and  the  reserves 
against  such  assets  on  the  other,  then  the  reserves  must  be 
included  among  the  liabilities  in  order  that  the  aggregate  of  one 
side  may  be  deducted  from  the  other  so  as  to  determine  net  worth. 


3  See  Income  Tax  Procedure^  192 1,  page  833  et  seq. 


270  AUDITING— GENERAL  PRINCIPLES 

This  procedure  must  not  be  confused  with  the  criticism  of  the 
form  of  balance  sheet  which  shows  on  one  side  or  the  other  items 
which  are  neither  assets  nor  habihties  nor  deductions  from 
either  class.  Any  amount  directly  related  to  an  actual  asset 
or  liability  may  be  grouped  with  it  without  violating  the  rule 
against  the  misuse  of  these  two  terms. 

The  author's  test,  therefore,  is  that  a  reserve  account,  to 
properly  appear  among  the  liabilities  (or  as  the  equivalent  of 
liabilities)  on  a  balance  sheet,  must  represent: 

1.  Estimated  amounts  beHeved  to  have  accrued  and  which, 
when  determined,  will  be  actual  liabilities,  such  as  accrued  inter- 
est, wages,  taxes,  etc. 

2.  Items  deductible  from  assets  to  reduce  the  latter  to  their 
true  value,  such  as  depreciation  and  obsolescence  of  plant, 
exhaustion  of  mines,  estimated  loss  on  accounts  receivable,  etc. 

3.  Contingent  liabiHties,  such  as  the  contingencies  which  are 
discussed  in  these  pages,  but  the  reserve  should  be  based  on  evidence 
more  tangible  than  mere  conservatism.  A  vague  feeling  that  some- 
thing may  have  been  overlooked  which  would  decrease  the  assets 
or  increase  the  liabilities  is  not  the  proper  subject  for  a  reserve. 
Conservative  management  *' reserves"  part  of  its  surplus  for  such 
contingencies,  but  it  appears  as  surplus  and  not  as  a  liability. 

In  a  case  involving  the  valuation  of  capital  stock  for  the 
payment  of  transfer  tax,  the  court  held  that  an  amount  reserved 
for  contingencies  should  not  be  deducted  in  arriving  at  the  value 
of  the  capital  stock  of  a  corporation.  ^  The  court  referred  to  the 
reserve  as  follows:  ''As  this  is  a  reserve  for  contingencies  which 
may  never  happen.  ..." 

4.  The  reserve  of  an  insurance  company  is  usually  an  actual 
liability,  i.e.,  income  has  been  received  and  treated  as  gross 
income,  whereas  part  only  has  been  earned,  as  in  the  case  of  fire 
insurance  and  similar  companies  where  premiums  are  paid  in 
advance,  and  in  which  the  unearned  portion  should  be  carried  as  a 


4  In  re  Moore's  Estate,  161  N.  Y.  S.  142;  97  Misc.  Rep.  238  (Surrogate's 
Court,  New  York  County,  October  30,  1916). 


BALANCE  SHEET  AUDIT— CAPITAL  STOCK  27 1 

liability.  Theoretically,  the  aggregate  of  this  unearned  income 
forms  a  reserve  for  reinsurance,  the  theory  being  that  if  a 
company  desires  to  suspend  business,  it  can  reinsure  its  risks  out 
of  the  reserve  and  thus  leave  its  capital  and  surplus  intact. 
Likewise,  life  insurance  companies  not  only  collect  premiums  in 
advance,  but  they  also  collect  more  than  is  sufficient  to  pay  for 
the  insurance  carried.  The  excess  is  returnable  to  the  insured 
under  the  contract,  and  is  therefore  a  liability,  and  not  part  of 
the  accumulated  surplus  of  the  company.  Under  some  policies 
the  excess  is  rebated  annually,  under  others  no  distribution  is 
made  until  the  policy  expires.  From  an  accounting  point  of  view  a 
mutual  insurance  company  has  no  surplus,  since  it  agrees  to  insure 
at  cost.  All  excess  premiums  received  are  the  property  of  the  in- 
sured. Of  course  a  life  insurance  company  should  be  conservative 
to  the  last  degree,  and  it  may  be  that  it  would  not  be  safe  to  allo- 
cate all  of  the  estimated  excess  income  to  specific  policy-holders. 

All  of  the  classes  of  reserves  just  enumerated  have  been  or 
will  be  fully  discussed  under  their  respective  heads.  The  so- 
called  reserves  which  are  not  charges  against  income,  but  which 
are  set  aside  after  net  income  is  determined,  and  which  there- 
fore are  in  reality  divisions  of  surplus  account,  will  be  discussed 
under  the  general  title  of  ^'Surplus." 

CAPITAL  STOCK 

Having  discussed  the  asset  side  of  the  balance  sheet,  and 
having  enumerated  all  of  the  obligations,  certain  and  uncertain, 
which  should  appear  on  the  opposite  side  thereof,  the  auditor 
should  devote  particular  attention  to  the  treatment  of  what 
may  be  termed  the  net  worth  of  a  firm  or  corporation.  By  this 
is  meant  the  excess  of  assets  over  liabilities. 

Balance  Sheet  Construction 

Primarily  a  balance  sheet  is  prepared  for  the  information  of 
the    proprietors    (including    stockholders)    whose    assets    and 


272  *  AUDITING— GENERAL  PRINCIPLES 

liabilities  are  therein  set  forth.  The  sole  interest  of  the 
proprietors  being  to  ascertain  the  net  worth  of  their  property, 
the  logical  form  of  a  balance  sheet  is  to  show  the  net  worth  clearly. 
But  this  is  not  done  when  assets  are  shown  on  one  side,  while  on 
the  other,  under  the  general  heading  *' liabilities,"  there  appear 
in  the  following  order:  capital  stock  (not  a  liability),  accounts, 
notes  payable,  etc.,  reserves  (some  being  liabilities,  some  not), 
and  surplus,  the  total  exactly  agreeing  with  the  total  of  the 
assets. 

The  average  investor  does  not  understand  accounts.  How 
can  he  determine  the  net  worth  of  the  business  of  which  he  is  a 
part  owner?  The  proper  way  to  enlighten  him  is  to  classify  the 
balance  sheet  items.  The  assets  should  be  shown,  then  the 
liabilities;  the  excess  of  assets  over  liabilities  (if  any)  should 
appear  next;  finally  the  capital  or  capital  stock  and  surplus 
representing  such  excess.  If  it  is  desired  to  set  aside  part  of  the 
surplus  for  other  purposes,  the  segregation  should  be  shown  on 
the  balance  sheet.  In  the  case  of  a  corporation,  all  capital  stock 
and  surplus  items  should  be  grouped  together  in  the  balance 
sheet;  when  feasible  one  footing  should  be  shown  of  the  aggregate, 
which  constitutes  the  net  worth  of  the  corporation. 

There  can  be  proper  grouping  when  it  is  desired  to  state  the 
assets  and  liabilities  in  parallel  columns  with  the  totals  of  the  two 
columns  in  agreement,  ^  as  well  as  when  the  assets  are  stated  first 
and  the  liabilities  thereunder,  followed  by  the  capital  plus  the 
surplus,  or  capital  less  the  deficit,  as  the  case  may  be.  ^  In  both 
cases  it  should  be  noticed  that  the  only  variation  of  any  con- 
sequence from  the  form  criticized  is  in  the  captions  and  the 
groupings.  But  since  these  are  read  seriously  by  many  business 
men,  care  should  be  taken  to  use  terms  as  nearly  descriptive  of 
the  items  to  which  they  apply  as  possible. 

There  is  little  defense  for  the  form  of  balance  sheet  which 
shows  capital  and  surplus  as  liabilities,  and  deficit  as  an  asset.    It 

5  See  page  369. 

^  See  pages  367-368. 


BALANCE  SHEET  AUDIT— CAPITAL  STOCK  273 

is  true  that  it  enables  an  accountant  to  set  down  two  sets  of 
figures  which  exactly  balance,  and  the  author  freely  admits  that 
some  of  the  best  corporations  and  some  of  the  best  firms  of 
accountants  use  this  form;  but  in  his  opinion  the  practice  is 
merely  the  outgrowth  of  custom  and  expediency  and  will  be 
changed  in  time. 

Auditor's  Certification  Limited. — Whether  stock  is  issued 
with  or  without  par  value,  it  is  customary  for  the  directors  to  fix 
the  values  of  the  assets  paid  in  for  such  stock.  Although  an 
auditor  is  not  supposed  to  certify  to  anything  which  he  knows  is 
not  true,  we  have  not  yet  reached  the  point  where  an  auditor  is 
justified  in  volunteering  an  opinion  that  capital  stock  issued  in 
payment  for  property  acquired  is  not  full-paid  because  in  his 
opinion  the  property  is  not  worth  the  amount  of  stock  issued 
therefor,  whether  at  par  or  at  stated  values  to  be  ascribed  to 
no-par  value  shares.  Of  course,  in  a  special  investigation,  an 
auditor  may  be  asked  to  investigate  points  of  this  kind,  but  when 
in  an  ordinary  audit  stock  has  been  issued  for  property,  and  the 
records  are  in  satisfactory  shape,  the  auditor  is  not  compelled 
to  challenge  the  good  faith  of  the  directors. 

Audit  Procedure 

The  auditor  should  examine  the  corporation's  charter  or 
certificate  of  incorporation,  the  by-laws,  and  the  board  minutes, 
for  information  relative  to  the  authorized  capital  stock,  the 
method  of  payment,  and  all  other  provisions  governing  its 
issuance.  He  should  ascertain  that  there  has  been  no  overissue, 
by  examining  the  certificate  books  and  stock  ledgers,  and  he 
should  verify  the  proceeds  of  its  sale.  In  many  states  capital 
stock  can  now  be  issued  with  or  without  par  value. 

Of  late  years  it  has  become  popular  to  adopt  by-laws  which 
require  certain  amounts  of  current  assets  to  be  maintained, 
certain  reserves  to  be  created,  etc.  The  auditor  should  verify 
all  of  these  requirements. 

VOL. I — 18 


274  AUDITING— GENERAL  PRINCIPLES 

If  stock  has  been  sold  on  the  instalment  plan,  the  auditor 
should  ascertain  that  the  calls  have  been  promptly  met  and 
whether  or  not  any  are  in  arrears.  If  special  terms  have  been 
extended  to  any  stockholder,  approval  of  the  board  is  necessary. 

Certificates  should  be  secured  from  transfer  agents  and 
registrars  if  any  are  acting  in  that  capacity  for  the  corporation 
under  audit.  If  the  stock  were  all  in  the  hands  of  stock-brokers 
or  financial  institutions,  it  might  be  assumed  that  the  certificates 
were  conclusive;  but  so  many  stockholders  fail  to  insist  upon  the 
simplest  precautions  and  safeguards  that  it  may  be  taken  for 
granted  that  in  spite  of  the  blanks  on  the  face  of  the  certificates, 
the  average  stockholder  will  accept  as  genuine,  stock  certificates 
which  do  not  bear  the  proper  signatures.  Furthermore,  the 
corporation  clerk  or  official  who  wishes  to  defraud  will  cheerfully 
fill  in  all  of  the  necessary  signatures. 

Certificates  from  registrars  or  transfer  agents  should  in  all 
cases  be  requested,  but  they  cannot  be  depended  upon  as 
conclusive  evidence  that  there  is  no  additional  stock  outstanding. 

An  Illustration. — The  author's  attention  was  called  to  a 
case  in  which  the  president  of  a  bank  drew  certificates  of  stock  in 
his  own  name,  and  filled  out  the  stub  of  the  certificate  for  2 
shares  and  the  certificate  itself  for  200  shares.  The  cashier  had 
previously  signed  the  blank  certificate.  Proper  payment  was 
made  for  2  shares.  The  certificate  was  then  sent  to  the  registrar's 
office  and  duly  recorded  for  200  shares.  The  president  sold  this 
stock  and  fraudulently  retained  the  proceeds.  The  stock  was  not 
fully  issued,  which  explains  the  action  of  the  registrar;  if  there 
were  an  overissue,  the  registrar  would  refuse  to  validate  the  stock. 

In  this  case  the  certificate  of  the  registrar  would  have  disclosed 
the  fraud. 

No-Par  Value  Stock 

When  capital  stock  has  a  par  value,  the  term  "capital  stock" 
represents  merely  the  par  value.    When  stock  having  no  par 


BALANCE  SHEET  AUDIT— CAPITAL  STOCK  275 

value  is  issued,  the  term  ''capital  stock"  includes  the  entire 
excess  of  assets  over  liabilities  represented  by  the  entire  number 
of  shares  issued;  if  there  are  shares  of  par  value  and  also  shares 
of  no  par  value,  the  term  ''capital  stock"  means  the  total  par 
value  of  the  par  value  shares  and  the  balance  of  the  excess  of 
assets  over  liabilities  as  representing  the  no-par  value  capital 
stock.  When  there  are  accumulated  unpaid  dividends  upon 
preferred  stock,  the  aggregate  amount  unpaid  should  be  shown  in 
the  balance  sheet;  otherwise  the  equity  accruing  to  the  no-par 
value  stock  is  overstated. 

The  situation  is  the  same  when  a  minimum  stated  value  or 
multiples  of  such  value  may  or  must  be  ascribed  to  each  share 
issued.  The  term  "capital  stock"  is  broad  enough  to  embrace 
the  arbitrary  stated  value  and  any  excess  value.  The  provisions 
of  the  state  laws  regarding  stated  or  minimum  amounts  are 
merely  regulatory  for  the  protection  of  creditors.  They  are  not 
intended  to,  and  do  not,  change  the  meaning  of  the  term  "capital 
stock." 

Procedure. — ^There  is  a  constantly  increasing  tendency  to 
issue  shares  of  capital  stock  having  no  par  value.  The  method 
of  verification  of  the  total  number  of  shares  outstanding  does 
not  differ  from  the  procedure  suggested  for  par  value  stock.  ^ 
The  amount  at  which  the  stock  is  carried  usually  represents  the 
proceeds  of  the  sale  of  the  stock.  In  some  states  the  corporation 
laws  require  a  minimum  or  stated  value  to  be  paid  in  respect  of 
each  share  authorized,  even  though  a  less  number  of  shares  may 
be  issued.  There  are  so  many  special  provisions  that  it  is  not 
practicable  to  enumerate  them  in  this  book.  The  auditor  can 
readily  secure  copies  of  the  requirements  in  any  state  and  be 
governed  accordingly.  There  should  be  little  difficulty  in  deter- 
mining the  best  method  of  stating  no-par  value  stock  in  a  balance 
sheet,  although  there  are  instances  of  improper  statements  which 
must  be  checked,  or  else  the  chief  advantage  of  no-par  value 


7  See  page  274. 


276  AUDITING— GENERAL  PRINCIPLES 

stock,  viz.,  honesty  in  stating  net  worth,  will  be  lost.  When 
assets  are  fairly  valued  at  incorporation,  the  excess  over  liabilities 
should  appear  as  paid-in  capital,  irrespective  of  the  number  of 
shares  authorized  or  issued.  The  number  of  shares  issued  should 
be  so  stated  that  it  will  be  possible  to  calculate  at  a  glance  the 
book  value  of  each  share.  The  number  of  shares  authorized 
should  be  stated  for  information  purposes.  When  state  laws 
require  a  stated  value  to  be  paid  in  and  shown  for  each  share, 
the  aggregate  thereof  may  be  shown  in  one  amount  and  the 
excess  of  net  worth,  if  any,  stated  as  capital  surplus.  There  are 
differences  of  opinion  as  to  whether  or  not  capital  surplus  may  be 
used  to  pay  dividends.  Some  good  authorities  hold  that  it  may, 
others  hold  that  it  may  not.  It  is  a  legal  question  to  be  settled 
by  the  courts.  No  matter  how  it  is  settled,  auditors  should  take 
the  position  that  the  excess  of  assets  at  time  of  incorporation 
constitutes  the  capital  of  the  corporation,  and  that  any  payments 
of  dividends  out  of  such  funds  (except  as  liquidating  dividends) 
are  grossly  improper — if  not  illegal.  Balance  sheets  should 
clearly  show  subsequent  operations.  Net  income  should  be 
shown  as  earned  surplus;  a  deficit  should  be  shown  on  the  balance 
sheet  as  a  deduction  from  capital  surplus  or  stated  capital.  Any 
concealment  of  a  deficit,  accomplished  by  closing  it  into  capital 
surplus,  without  showing  the  two  accounts  separately,  is,  or 
may  be  construed  to  be,  a  deception  on  those  who  use  the  balance 
sheet.  There  is  no  objection  to  applying  a  deficit  arising  from 
operations  against  capital  surplus;  but  the  practice  is  only  per- 
missible when  the  deduction  is  shown  in  the  balance  sheet  of  the 
year  when  the  deficit  is  sustained. 

*The  author  reiterates  that,  even  though  state  laws  may 
permit  corporations  to  fix  the  amount  of  capital  which  may  not 
be  impaired  by  the  distribution  of  dividends,  the  privilege  is 
purely  technical.'  There  is  just  as  much  moral  turpitude  in 
paying  a  dividend  out  of  so-called  capital  surplus  as  out  of  capital, 
because  in  every  way,  except  the  bare  legal  distinction,  they  are 
the  same  and  should  be  equally  safeguarded. 


BALANCE  SHEET  AUDIT— CAPITAL  STOCK  277 

The  subject  has  been  fully  discussed  by  accountants;  good 
accounting  practice  requires  that  capital  surplus  at  organization 
be  clearly  segregated  and  at  no  time  be  merged  with  surplus 
arising  from  operations.  The  accounts  should  not  be  stated 
to  excuse  or  justify  in  any  possible  way  the  use  of  capital  sur- 
plus for  cash  dividends;  if  any  doubt  exists  the  entire  amount 
applicable  to  no-par  value  shares  at  organization  should  be 
designated  as  capital,  and  the  word  *'  surplus  "  be  omitted. 

Restrictions  Affecting  Transfers  of  Capital  Stock 

Some  corporations  have  special  clauses  in  their  by-laws  which 
restrict  the  transfer  of  the  capital  stock.  In  several  cases  this 
has  been  held  to  be  illegal  and  such  clauses  deemed  void  on  the 
ground  that  capital  stock  is  personal  property  and  its  sale  should 
not  be  unduly  restricted.^  The  restrictions  are  binding  upon 
those  who  have  notice  of  them,  but  are  not  binding  upon  inno- 
cent purchasers  for  value.  When  stock  is  sold  to  employees 
and  deliveries  are  made  of  the  certificates,  there  is  an  implied 
power  of  assignment.  When  it  is  desirable  that  the  right  to 
transfer  the  shares  be  limited,  the  result  can  be  secured  by 
printing  the  restrictions  on  the  certificates.  Any  reasonable 
agreements  among  stockholders  may  be  enforced  if  care  is  taken 
to  prevent  transfers  to  those  who  have  no  notice  of  the 
agreements.  This  is  a  question  which  arises  in  a  great  many 
close  corporations  and  the  auditor  should  be  in  a  position  to 
advise  regarding  it. 

Stock  Dividends 

A  stock  dividend  is  a  dividend  declared  by  a  corporation, 
payable  in  stock  of  the  same  corporation.     As  there  is  no  actual 


8  Johnston  v.  Laflin,  103  U.  S.  800  (1880). 
McNuUa  V.  Corn  Belt  Bank,  164  111.  427  (1897). 
Quiner  v.  Marhlehead  Social  Insurance  Co.,  10  Mass.  476  (1813). 
Morris  v.  Hussong  Dyeing  Machine  Co.,  81  N.  J.  Eq.  256  (1913). 
Steele  v.  Farmers',  etc..  Association,  95  Kan.  580;  148  Pac.  661  (1915). 
Kretzer  v.  Cole  Bros.,  etc.,  Co.,  193  Mo.  App.  99;  181  S.  W.  1066  (1916). 
Longyear  v.  Hardman,  219  Mass.  405  (19 14). 


278  AUDITING— GENERAL  PRINCIPLES 

change  in  the  stockholders'  interests,  stock  dividends  are  dis- 
tinguished from  cash  and  property  dividends  in  which  actual 
distributions  take  place.  When  a  stock  dividend  is  declared 
there  is  a  debit  to  surplus  and  a  credit  to  capital  stock.  The 
surplus  is  said  to  be  capitalized.  From  the  point  of  view  of  the 
auditor,  no  question  of  principle  is  involved.  Unlike  cash 
dividends,  there  is  no  objection  to  declaring  stock  dividends 
from  capital  surplus  or  from  other  surplus  accounts  such  as 
premiums  on  capital  stock.  It  is  important,  however,  that  the 
recipients  of  stock  dividends  which  are  not  charged  to  earned  sur- 
plus should  be  fully  informed  as  to  the  source  of  the  dividends. 
Obviously  the  value  of  the  new  stock  is  affected  by  the  source 
from  which  it  was  derived.  The  auditor  should  take  care  to 
mention  prominently  the  facts  in  his  report  and  certificate. 

Premiums  on  Capital  Stock 

When  stock  has  been  sold  at  a  premium,  the  auditor  should 
see  that  all  premiums  have  been  collected.  The  funds  so  realized 
should  be  credited  to  premiums  on  capital  stock  account,  which 
should  remain  open,  and  appear  on  the  balance  sheet  as  a  special 
surplus  account.  In  no  event,  however,  should  the  account  be 
transferred  to  general  surplus  and  thus  be  looked  upon  as  avail- 
able for  cash  dividends.  It  is  probably  legal  to  declare  a  cash 
dividend  out  of  funds  so  raised,  but  such  action  would  be 
sufficient  to  sustain  a  charge  of  dishonesty  against  the  directors 
who  vote  for  it. 

SURPLUS 

The  term  *' surplus"  in  the  balance  sheet  should  have  a 
meaning  as  specific  as  any  item  of  the  assets  or  of  the  liabilities. 
The  *' surplus"  of  a  corporation  should  represent  an  actual  sur- 
plus, that  is,  a  balance  of  net  income  after  all  reserves  have  been 
provided,  including  the  reserves  of  surplus,  such  as  working 
capital.  The  balance  thus  represents  an  amount  safely  dis- 
tributable as  dividends. 


BALANCE  SHEET  AUDIT— SURPLUS  279 

Nature  of  Surplus. — This  does  not  mean  that  there  must  be 
cash  on  hand  sufficient  to  pay  the  whole  amount  of  surplus  in 
dividends,  but  it  does  mean  that,  if  at  any  time  there  are  surplus 
funds,  the  directors  can  rely  on  the  integrity  of  the  surplus 
account  and  cannot  lay  themselves  open  to  an  action  for  paying 
dividends  out  of  capital,  or  before  reserves  for  compulsory  sinking 
funds,  etc.,  have  been  created.  Surplus  is  just  as  much  a  part 
of  capital  as  is  capital  itself.  It  becomes  capital  in  fact  from  day 
to  day  as  it  accumulates,  and  it  decreases  from  day  to  day  by 
means  of  losses  or  dividends.  It  becomes  capital  in  theory  once 
a  year^but  only  because  of  expediency  or  convenience. 

Surplus  Is  Not  a  ''Fund." — It  is  not  unusual  to  find  surplus 
accounts  referred  to  as  '' surplus  funds."  Such  terminology  is 
incorrect;  surplus  accounts  may  represent  funds  if  specific  assets 
are  segregated;  usually,  however,  the  amounts  to  the  credit  of 
surplus  accounts  are  represented  by  undivided  interests  in  net 
assets.  The  word  *'fund"  imports  something  that  is  tangible 
and  its  use  should  be  limited  to  tangible  assets. 

Analysis  of  Surplus. — The  separation  of  surplus  into 
accounts  which  disclose  its  composition  frequently  affords  infor- 
mation of  great  importance  to  those  who  use  balance  sheets. 
Consolidation  of  the  surplus  accounts  is  sometimes  resorted  to 
when  there  is  a  desire  to  conceal  material  changes  in  financial 
condition.  Good  accounting  practice  requires  proper  segregation 
and  does  not  sanction  the  consolidation  of  surplus  accounts  when 
such  action  tends  to  make  a  balance  sheet  less  understandable. 

Accretions  to  capital  arising  from  reappraisals,  from  sales  of  cap- 
ital assets,  from  gifts,  from  premiums  on  capital  stock,  etc.,  are 
known  as  capital  surplus.  When  the  amounts  are  substantial,  sep- 
arate accounts  for  each  should  be  shown.  The  excess  of  the  book 
value  of  assets  over  liabilities  and  capital  stock  at  the  time  of 
incorporation  is  known  as  paid-in  surplus.  Subsequent  contri- 
butions by  stockholders,  in  cash  or  property,  when  additional 
capital  stock  is  not  issued,  are  also  a  part  of  paid-in  surplus. 


28o  AUDITING— GENERAL  PRINCIPLES 

Accretions  to  capital  from  earnings  constitute  *' earned" 
surplus;  earnings  which  corporations  agree  to  set  aside  as  not 
available  for  current  dividends  are  known  as  ''appropriated" 
surplus. 

The  term  "undivided  profits"  usually  refers  to  the  balance  of 
current  net  income  not  transferred  to  surplus  account  in  the  books. 
There  is  no  actual  difference  between  the  terms,  ''earned  sur- 
plus" and  "undivided  profits,"  except  in  the  case  of  national 
and  state  banks  and  trust  companies,  which  make  a  distinction 
between  surplus  and  undivided  profits;  the  amounts  which  are 
definitely  transferred  to  surplus  are  treated  as  additional  capital, 
and  are  not  available  for  dividends. 

Surplus,  in  the  balance  sheet,  should  be  divided  into  three 
general  groups:^ 

1.  Capital  Surplus 

2.  Appropriated  Surplus 

3.  Surplus 

The  first  and  third  groups  are  self-explanatory.  It  is  important, 
however,  to  ascertain  that  capital  surplus  is  not  diminished 
by  operating  losses,  nor  by  dividends,  unless  the  dividends  have 
specifically  been  declared  from  capital.  Any  changes  in  capital 
surplus  during  a  fiscal  period  should  be  shown  in  detail  in  the 
balance  sheet  or  in  accompanying  schedules.  This  precaution  is 
of  unusual  importance  when  no-par  value  stock  appears  in  a 
balance  sheet. 

It  is  not  necessary  to  credit  the  profit  from  the  sale  of  capital 
assets  to  capital  surplus.  It  is  true  that  earned  surplus  should 
represent  net  income  derived  from  the  normal  operations  of  a 
business;  but  profits  realized  from  extraordinary  sources  are  not 
true  capital  surplus.  \  Capital  surplus  arises  from  contributions 

9  Possibly  a  fourth  group  should  be  set  up  to  include  items  of  liabilities 
completely  subordinated  to  all  other  creditors.  (See  page  224  for  discussion.) 
From  the  point  of  view  of  net  worth  available  to  pay  creditors,  the  items  belong 
in  the  capital  group,  ranking  as  a  special  class  of  stock;  but  as  an  actual  lia- 
bility exists,  merely  ranking  after  other  liabilities,  it  is  incorrect  to  include  the 
items  with  surplus  accoimts. 


BALANCE  SHEET  AUDIT— SURPLUS  28 1 

by  the  owners  of  a  business;  profits  arising  from  any  subsequent 
dealings  with  the  public  are  not  in  the  same  class.  It  has  been 
said  that  when  treasury  stock  is  purchased  at  a  discount,  paid-in 
or  capital  surplus  should  be  credited  with  the  discount.  This  is  a 
fallacy  since  there  has  been  no  new  contribution  of  capital.  One 
of  the  owners  surrenders  his  interest  for  less  than  its  book  value 
and  the  remaining  owners  have  a  greater  relative  interest  in  book 
values  than  before  the  purchase;  but  the  actual  result  is  an 
appraisal  of  book  values  at  less  than  face  value.  The  transaction 
is  not  one  which  justifies  writing  up  any  surplus  account. 

There  is  little  net  or  final  difference  between  the  profit  arising 
from  the  sale  of  normal  product  and  from  the  sale  of  surplus 
plant.  Plant  or  property  accounts  may  have  been  excessively 
depreciated  so  that  apparent  profits  realized  from  sales  do  not 
represent  actual  net  profits.  When  capital  assets  disposed  of  at 
a  profit  are  to  be  replaced,  it  is  not  expedient  (although  it  is  not 
improper  accounting  practice)  to  credit  the  profits  to  earned  sur- 
plus, since  the  gross  proceeds  of  the  sale  presumably  will  have  to 
be  used  in  making  the  replacements.  Under  such  circumstances 
the  profits  should  be  credited  to  special  surplus  or  to  replace- 
ment accounts  and  not  made  available  for  cash  dividends. '  '^ 

"It  may  be  said,  therefore,  that  profits  arising  from  sales  of 
capital  assets  are  capital  or  special  surplus  or  earned  surplus, 
depending  on  the  disposition  of  the  proceeds.  ^ 

..  There  is  no  real  distinction  between  capital  surplus  and 
paid-in  surplus.  The  latter  term  appears  in  excess  profits  tax 
procedure  as  a  convenient  term  to  describe  capital  surplus  arising 
from  specific  sources."  The  term  should  not  otherwise  be  used. 
As  stated  elsewhere,  surplus  may  be  divided  or  appropriated  by 
contracts  with  creditors  or  other  outsiders  or  by  action  of  boards 
of  directors;  so  far  as  balance  sheets  are  concerned  there  need 


"»  Under  federal  tax  procedure  the  proper  segregation  and  disposition  of 
the  proceeds  render  the  profits  non-taxable.  See  Income  Tax  Procedure,  1921, 
page  585. 

^^  For  discussion  of  paid-in  surplus,  see  Excess  Profits  Tax  Procedure,  192 1, 
page  152. 


282  AUDITING— GENERAL  PRINCIPLES 

be  only  two  groupings :  one  to  represent  capital  or  appropriated 
surplus,  the  other  free  or  earned  surplus. 

Capital  surplus  and  earned  surplus  are  terms  frequently  used 
in  tax  laws  and  regulations.  In  general,  tax  procedure  should 
follow  good  accounting  practice,  except  when  tax  laws  are  specific 
in  departure  therefrom.  When  tax  laws  do  not  define  capital 
and  income,  good  accounting  practice  governs. ' "" 

The  second  group  should  be  divided  into  as  many  separate 
accounts  as  are  necessary  to  show  clearly  all  compulsory  and 
voluntary  segregations.  As  to  compulsory  segregation,  we 
find  the  following  reserves  for  retirement  of  securities: 

(a)  Reserves  for  retiring  bonds,  notes,  etc. 

(b)  Reserves  for  retiring  preferred  stock. 

As  to  voluntary  segregation  we  find : 

(a)  Reserves  for  working  capital. 

(b)  Reserves  for  dividends. 

Reserves  for  Retirement  of  Securities 

In  many  issues  of  bonds,  notes,  and  preferred  stock  stipu- 
lations are  contained  which  require  the  setting  up  of  reserve 
accounts.  Some  of  the  conditions  upon  which  these  reserves 
are  based  are:  realizations  of  wasting  assets;  fixed  instalments, 
i.e.,  specific  sums  or  specific  percentages  of  outstanding  issues; 
dividends  paid;  stated  percentages  of  net  profits.  There  are 
many  others.  It  is  not  necessary  to  enumerate  the  reasons  for 
and  the  importance  of  providing  the  reserves,  as  such  reasons 
differ  according  to  the  terms  of  the  agreements  under  which  the 
securities  are  authorized  and  issued.  A  careful  reading  of  the 
entire  text  which  appears  in  the  obligations  or  the  preferred  stock 
certificates  will  inform  the  auditor  as  to  the  specific  requirements 
to  be  met. 


'  ^  For  detailed  discussion  of  capital  and  surplus  accounts  in  relation  to  tax 
matters,  see  Income  Tax  Procedure,  1921,  and  Excess  Profits  Tax  Procedure, 
192 1. 


BALANCE  SHEET  AUDIT— SURPLUS  283 

Treatment  of  Reserves. — It  is  not  enough  that  reserve 
accounts  be  set  up;  the  subsequent  handHng  of  the  accounts  is  of 
equal  importance.  The  requirements  in  some  agreements  are 
ambiguous,  therefore  a  correct  understanding  of  the  intention  of 
investors  (rather  than  the  intention  of  the  corporations)  is  of 
great  importance.  The  underlying  purpose  of  requirements 
governing  sinking  fund  or  retirement  reserve  accounts  is  to  limit 
or  prevent  the  payment  of  dividends  on  junior  securities.  In 
the  case  of  bonds  and  notes  the  intention  is  to  limit  or  prevent 
dividends  on  stock;  in  the  case  of  preferred  stock  the  intention 
is  to  limit  or  prevent  dividends  on  common  stock.  This  inten- 
tion is  negatived  if  the  surplus  available  for  dividends  is  not 
permanently  reduced  by  the  full  amount  of  the  reserves.  To  put 
it  affirmatively:  the  full  amount  of  the  reserves  which  corpo- 
rations agree  to  set  aside  to  retire  bonds,  notes,  or  stocks  must  be 
set  up  and  remain  in  appropriate  reserve  accounts  unless  and 
until  the  full  purposes  of  the  requirement  are  met. 

Even  though  the  reserve  accounts  are  largely  in  excess  of  the 
principal  amount  of  the  issues  to  be  retired  (through  periodical 
instalments),  it  is  not  proper  to  transfer  any  part  of  the  reserves 
to  general  surplus,  unless  the  original  agreement  so  provides,  or 
unless  the  original  agreement  has  been  modified  by  unanimous 
consent  of  the  interested  parties. 

In  view  of  the  purpose  of  :agreements  containing  sinking  fund 
provisions,  any  ambiguity  therein  must  be  decided  in  favor  of  the 
holders  of  the  senior  securities,  and  against  the  holders  of  the 
junior  securities. 

When  Reserve  May  Be  Carried  to  Surplus. — Under  some 
circumstances  it  may  not  be  proper  to  transfer  special  reserve 
accounts  to  general  surplus  even  though  the  provisions  in  specific 
agreements  are  fully  comphed  with.  A  corporation  may  increase 
its  working  capital  by  the  sale  of  preferred  stock.  It  may  set  up 
a  reserve  for  retirement,  and  in  time  retire  the  entire  issue.  In 
theory,  when  all  of  the  preferred  stock  is  retired  the  full  amount 


284  AUDITING— GENERAL  PRINCIPLES 

in  the  reserve  account  may  be  transferred  to  surplus.  In  practice 
creditors  usually  have  their  attention  called  to,  and  they  are 
asked  to  extend  credit  upon,  balance  sheets  in  which  large  reserve 
accounts  appeared,  which  were  segregated  from  surplus  available 
for  dividends.  If  a  new  balance  sheet  is  prepared  in  which 
the  reserve  account  is  merged  with  general  surplus  and  is  made 
available  for  dividends  on  the  common  stock,  it  may  be  con- 
tended that  a  distribution  which  would  include  any  substantial 
part  of  the  reserve  is  an  improper  diversion  of  working  capital. 
In  one  instance  a  corporation  sold  a  preferred  stock  issue  of 
$1,000,000.  After  receiving  the  proceeds  its  total  working 
capital  was  $1,500,000.  It  required  additional  funds  and  on  the 
strength  of  its  balance  sheet  secured  a  loan  of  $1,000,000.  Its 
net  earnings  during  ten  years  were  about  $1,000,000,  all  of  which 
were  used  to  retire  its  preferred  stock.  It  was  purposed  to 
transfer  the  reserve  account  ($1,000,000)  representing  the  retired 
stock,  to  general  surplus.  The  creditors  objected  on  the  ground 
that  if  any  part  thereof  were  paid  out  in  dividends  the  corpo- 
ration would  have  less  working  capital  than  when  the  loan  was 
made,  although  the  company  had  earned  $1,000,000  in  the 
meantime;  that  they  had  relied  on  the  reservation  of  profits  in  the 
retirement  account;  that  there  was  no  provision  in  the  agreement 
whereby  the  reserve  account  could  be  transferred  to  surplus; 
and  that  it  was  entirely  reasonable  that  the  common  stockholders 
should  not  be  permitted  to  receive  funds  which  in  effect  were 
derived  from  borrowed  money. 

The  dispute  was  not  litigated  because  the  decision  was  left 
to  the  auditors,  who  decided  that  the  reserve  account  must 
stand  until  all  of  those  who  claimed  to  rely  upon  it  were  satisfied. 

Sinking  Fund  Reserves. — Reserves  for  depreciation,  when 
calculated  scientifically,  should  be  deducted  from  the  assets 
affected  or  else  should  be  shown  as  habilities.  Sinking  fund 
requirements  are  usually  in  excess  of  actual  depreciation  or 
exhaustion  reserves,  so  that  the  proper  method  must  be  adopted 


BALANCE  SHEET  AUDIT— SURPLUS  285 

to  show  that  sinking  fund  requirements  have  been  legally  com- 
plied with;  at  the  same  time  the  assets  and  liabilities  should  be 
exhibited  as  they  actually  exist. 

For  illustration,  a  mortgage  covering  coal  lands  may  require 
the  payment  to  the  trustee  of  10  cents  per  ton  mined.  The 
exhaustion  charge  based  on  engineers'  estimates  may  be  5  cents 
per  ton.  The  reason  for  the  difference  is  obvious.  The  holder 
of  a  bond  does  not  care  to  take  the  chance  of  waiting  until  the 
last  ton  is  removed  before  receiving  the  last  of  his  principal. 

Correct  Procedure. — In  order  to  sell  bonds  the  security 
Jiust  be  ample  and  a  considerable  margin  must  be  allowed  for 
errors  in  estimates.  Most  often  the  mortgage  will  require  that 
the  sinking  fund  shall  be  a  charge  against  earnings.  This  is 
reasonable,  since  it  serves  to  prevent  the  payment  of  excessive 
dividends  until  the  bonds  are  all  retired.  However,  there  is  no 
reason  why  the  stockholders  should  be  kept  in  ignorance,  in  the 
meantime,  as  to  the  true  earnings  realized,  even  if  they  are  not 
entirely  available  for  dividends  while  the  bonds  remain  unpaid. 

Therefore,  the  only  way  to  show  the  exact  (or  as  nearly  exact 
as  possible)  earnings  is  to  carry  a  reserve  for  exhaustion  account 
among  the  liabilities  equal  to  5  cents  per  ton,  and  a  reserve  for 
sinking  fund  account  equal  to  an  additional  5  cents  per  ton  as  a 
segregated  part  of  the  surplus.  After  all  of  the  bonds  are  retired 
this  reserve  account  is  closed  into  the  general  surplus  account. 

The  reserve  for  exhaustion  account  should  be  sufficient  to 
equal  the  book  value  of  the  property  account  by  the  time  the  coal 
is  practically  exhausted.  This  rule  applies  irrespective  of  any 
special  requirements  for  sinking  fund  instalments,  and  irrespec- 
tive of  a  trust  deed  provision  to  the  effect  that  such  instalments 
are  a  charge  against  income.  All  fixed  or  wasting  assets  must  be 
kept  intact,  either  in  their  original  form  or  by  creating  an  equiva- 
lent in  cash  or  some  other  satisfactory  asset.  The  amounts 
required  to  maintain  this  equilibrium  are  charges  against  income, 
but  as  soon  as  the  instalments  are  in  excess  of  such  requirements. 


286  AUDITING— GENERAL  PRINCIPLES 

the  excess  forms  a  part  of  the  surplus  of  the  business  and  should 
be  shown  as  such.  The  question,  how  much,  if  any,  of  the  sur- 
plus is  available  for  dividends,  is  another  matter. 

Reserves  for  Retiring  Bonds,  Notes,  etc. — Reserves  for 
sinking  funds  bear  many  different  titles  in  published  balance 
sheets.  The  following  captions  appear  on  the  liability  side  of 
balance  sheets  bearing  the  certificates  of  well-known  accountants : 
sinking  fund;  sinking  fund  reserve;  reserve  for  sinking  fund; 
sinking  fund  accrued;  reserve  fund. 

The  most  descriptive  and  correct  title  is  *' reserve  for  retire- 
ment of  bonds."  It  is  settled  practice  to  use  the  terms,  *' reserve 
for  depreciation  of  plant "  and  '^  reserve  for  retirement  of  preferred 
stock,"  both  of  which  are  descriptive.  Usually  sinking  fund 
accounts  are  not  descriptive.  When  bonds  are  to  be  retired 
from  time  to  time  by  purchase,  etc.,  the  account  should  be 
^'  reserve  for  bond  retirement " ;  when  a  fund  is  being  accumulated 
to  redeem  bonds  at  maturity,  the  account  should  be  a  "reserve 
for  bond  redemption." 

Reserves  for  Retirement  of  Preferred  Stock  Bear 
Many  Different  Names. — Uniformity  is  desirable.  The  most 
descriptive  term  should  be  used,  viz.,  ''reserve  for  preferred 
stock  retirement."  There  is  no  objection  to  using  the  term 
''surplus  appropriated  for  preferred  stock  retirement,"  when  it 
does  not  otherwise  appear  that  the  account  is  a  segregation  of 
surplus. 

A  matter  of  increasing  interest  in  connection  with  preferred 
stock  issues  is  the  obligation  to  retire  part  of  an  issue,  usually  at  a 
considerable  premium,  at  fixed  dates,  or  under  other  conditions. 
In  most  cases  these  provisions  are  agreed  to  at  the  formation 
or  refinancing  of  a  company  when  the  future  prospects  seem  to 
warrant  large  appropriations  out  of  earnings  for  the  purpose  of 
retiring  preferred  stock.  Unfortunately,  these  optimistic  fore- 
casts have  not  always  been  realized,  and  there  have  been  many 
defaults  in  this  respect. 


BALANCE  SHEET  AUDIT— SURPLUS  287 

The  question  arises  as  to  the  change  of  status,  if  any,  on  the 
part  of  a  stockholder  who  owns  stock  on  which  a  default  exists. 
For  instance,  a  corporation  sold  $750,000  of  first  preferred  stock, 
subject  to  a  provision  for  the  retirement  of  $150,000  annually 
after  the  lapse  of  a  certain  period.  When  the  first  instalment 
became  due  the  corporation  was  unable  to  meet  its  obligation. 
The  certificate  contained  no  provision  bearing  on  the  treatment 
of  the  overdue  payment  in  the  accounts  or  in  the  balance  sheets. 
The  auditors  declined  to  certify  the  balance  sheet  until  a  decision 
was  reached  as  to  whether  or  not  the  amount  represented  a  lia- 
bility to  be  liquidated  as  soon  as  funds  were  available.  So  long 
as  this  possibility  existed  the  position  of  the  general  creditors  was 
subject  to  change.  Finally  it  was  decided  to  secure  an  extension 
from  all  stockholders  and  upon  satisfactory  evidences  thereof 
the  auditors  passed  the  balance  sheet. 

No  general  rule  can  be  laid  down  for  the  auditor's  guidance 
in  such  cases  as  this,  since  each  case  must  be  decided  on  its  merits. 
The  most  important  facts  for  the  auditor  to  ascertain  are:  the 
rights  of  stockholders  to  insist  upon  payment,  and  the  aggregates 
and  due  dates  of  all  probable  obligations.  Their  disposition  in 
the  accounts  is  then  a  matter  of  disclosing  full  information  to 
creditors,  prospective  creditors,  and  other  stockholders. 

Reserve  for  Working  Capital 

It  has  been  held  to  be  legal  to  set  aside  annually  or  at  other 
periods  out  of  the  earnings  of  a  company  a  reasonable  amount  as  a 
reserve  for  additional  working  capital,  which  is,  therefore,  not 
distributable  in  the  shape  of  dividends.  This  reserve  may  be 
temporary  or  permanent,  as  the  directors  determine.  It  cor- 
responds with  the  surplus  of  a  bank  or  trust  company,  which 
is  never  used  to  pay  dividends  unless  some  extraordinary  occa- 
sion arises.  The  account  is  a  discretionary  one  and  is  almost 
entirely  a  matter  of  bookkeeping,  or  rather  it  is  a  sort  of  no- 
tice to  stockholders  that  the  amounts  so  set  aside  will  not  be 
distributed. 


288  AUDITING— GENERAL  PRINCIPLES 

Treatment. — To  treat  such  an  account  as  a  liability  is  a 
fallacy,  because  at  any  time  the  directors  can  transfer  the  entire 
balance  to  general  surplus  and  pay  out  all  or  any  part  of  it  in 
dividends.  Therefore  the  account  should  always  appear  on  the 
balance  sheet  as  a  section  of  surplus,  but  never  among  the  lia- 
bilities. An  auditor  should  never  set  up  an  account  of  this 
nature  in  the  books  or  show  it  on  the  balance  sheet  unless  it  has 
been  formally  authorized  by  the  board  of  directors.  It  is  a 
commendable  practice  to  accumulate  a  substantial  surplus,  and  if 
the  directors  believe  that  the  temptation  to  declare  dividends 
is  less  if  the  surplus  account  proper  is  diminished  and  some  other 
account  with  a  different  name  is  increased,  the  auditor  should  not 
object.  But  such  segregation  of  profits  should  not  be  attempt- 
ed by  an  officer  of  a  company  on  his  own  initiative. 

Reserves  for  Dividends 

Capital  stock  is  not  a  liability,  nor  can  a  dividend  thereon  be  a 
liability  unless  action  has  been  taken  and  the  funds  have  been  set 
aside  to  pay  it.  When  this  is  once  done  the  action  of  the  directors 
cannot  be  rescinded  and  the  dividend  becomes  a  liability. 

A  definite  exception  to  this  rule  occurs  when  for  any  reason  it 
is  discovered  that  a  dividend  is  unwise  or  illegal  and  all  stock- 
holders agree  to  the  rescission.  When  the  dividend  has  not  been 
paid  it  is  merely  revoked  as  of  the  date  of  declaration;  when  the 
'dividend  has  been  paid,  all  of  the  stockholders  must  return  the 
amounts  received .  As  the  revocation  should  in  all  cases  be  effective 
as  of  the  date  of  declaration,  it  would  be  in  order  to  add  interest  to 
the  amounts  refunded;  but  since  the  stockholders'  distributable 
interests  are  not  affected,  it  is  not  necessary  to  add  interest. 

When  dividends  are  declared  prior  to  the  date  of  the  balance 
sheet  and  are  payable  soon  thereafter,  the  amount  should  be 
included  in  current  liabilities;  when  declared  a  year  in  advance 
the  amounts  payable  after  three  months  may  be  shown  sepa- 
rately, after  the  aggregate  of  the  current  liabiHties  is  shown. 
Reserves  are  sometimes  created  for  future  dividends  which  have 


BALANCE  SHEET  AUDIT— SURPLUS  289 

not  been  declared;  such  reserves  constitute  appropriated  surplus. 
When  dividends  are  declared  after  the  date  of  a  balance  sheet,  but 
before  it  is  published,  it  is  desirable  (but  not  compulsory)  to 
mention  it  in  the  balance  sheet. 

Unpaid  dividends  on  preferred  stock  often  accumulate  until 
paid  or  otherwise  disposed  of  by  compromise  or  other  settlement. 
This  preference,  however,  is  a  factor  against  the  common  stock 
only.  It  does  not  accumulate  as  a  liabiUty  and  is  not  deductible 
from  the  surplus,  if  any,  which  exists.  In  other  words,  a  corpo- 
ration may  have  a  book  surplus  more  than  sufficient  to  pay 
accumulated  preferred  stock  dividends,  but  so  long  as  no  dividend 
is  declared  by  the  directors  it  is  not  usual  to  make  any  book  entry 
therefor. 

Common  stockholders  usually  have  a  keen  interest  in  the 
value  of  their  shares,  and  therefore  it  is  not  only  permissible,  but 
desirable,  that  any  arrears  of  accumulated  dividends  should 
appear  as  a  footnote  or  memorandum  on  the  balance  sheet. 
There  does  not  seem  to  be  any  good  reason  against  the  appropri- 
ation of  sufficient  surplus  to  equal  the  accumulated  deficiency  in 
dividends.  It  does  not  affect  anyone's  legal  rights  and  it  conveys 
information  which  is  sometimes  difficult  to  secure.  Otherwise, 
in  the  opinion  of  the  author,  it  is  permissible  and  desirable  to  set 
up  reserves  for  accumulated  dividends. 

Investment  of  Surplus 

Common  questions  with  respect  to  the  surplus  account  are: 
*' Where  is  it?"  "What  asset  represents  it?"  Anyone  familiar 
with  accounts  understands  that  no  good  reason  exists  for  attempt- 
ing to  earmark  certain  assets  as  representing  surplus;  but  there  is 
some  foundation  for  the  skepticism  which  exists  concerning  the 
availability  of  many  so-called  surplus  accounts. 

The  best  answer  an  auditor  can  give  to  these  questions  is  to 
say  that  if  the  assets  are  not  overvalued,  the  surplus  truly  exists 
therein;  but  that  if  any  or  all  of  the  assets  are  overvalued,  then 
the  surplus  does  not  exist  to  the  extent  of  such  overvaluation. 

VOL. I — 19 


CHAPTER  XV 
THE  INCOME  ACCOUNT 

The  audit  of  balance  sheets  is  not  limited  to  the  verification 
of  asset,  liability,  and  capital  items;  it  is  necessary  to  verify  the 
item  which  represents  the  difference  between  the  total  assets 
as  adjusted  and  the  aggregate  of  the  liabilities  and  capital.  In 
the  case  of  sole  traders  and  partnerships,  accounts  representing 
the  net  income  or  deficit  do  not  appear  because  they  are  closed 
into  the  capital  accounts.  Nevertheless,  the  accounts  which  are 
closed  into  the  capital  accounts  should  be  scrutinized  in  the  same 
manner  as  if  the  balances  were  left  open. 

In  the  case  of  corporations,  the  difference  between  total  assets, 
and  total  liabilities  plus  capital  stock,  may  be  called  ^^  earned 
surplus,"  or  ''undivided  profits"  or  ''deficit";  if  no  item  of 
capital  surplus  appears,  the  term  "surplus"  will  be  assumed 
to  mean  "earned  surplus";  otherwise  the  distinction  between 
capital  surplus  and  earned  surplus  should  be  clearly  drawn. 

CAPITAL  AND  INCOME 

The  accuracy  of  balance  sheets  and  of  income  accounts 
depends  to  a  considerable  extent  upon  the  segregation  of  capital 
and  income.  It  is  a  matter  of  greatest  importance  to  avoid  the 
inclusion  of  capital  receipts  in,  and  the  exclusion  of  income 
deductions  from,  the  income  account;  otherwise  net  worth  and 
net  income  are  overstated.  From  the  standpoint  of  accuracy  it 
is  equally  important  to  avoid  the  inclusion  of  income  receipts  in, 
and  exclusion  of  capital  deductions  from,  the  capital  account; 
the  result  is  a  misstatement  of  net  worth  and  net  income.  From 
the  standpoint  of  conservatism  it  is  far  better  to  charge  capital 
items  to  income  than  it  is  to  charge  income  items  to  capital. 

290 


THE  INCOME  ACCOUNT  291 

When  there  is  no  doubt  about  the  items  good  accounting  practice 
does  not  sanction  the  charging  of  capital  items  to  income.  When 
a  doubt  exists  good  accounting  practice  sanctions  charges  to  in- 
come rather  than  to  capital. 

It  is  not  good  practice  to  charge  capital  expenditures  directly 
to  income;  but  there  is  no  objection  to  appropriations  of  net 
income  before  transferring  the  balance  to  surplus,  if  the  transfers 
are  clearly  shown. 

When  the  Pennsylvania  Railroad  Company  built  its  New 
York  terminal  a  considerable  part  of  the  cost  was  charged  to 
income.  The  net  income  was  first  stated  according  to  good 
accounting  principles  so  that  stockholders  were  informed  regard- 
ing actual  results;  the  proportion  of  capital  expenditure  charged 
against  income  was  shown  as  a  special  item. 

Form  of  Income  Account 

It  is  generally  accepted  practice  to  prepare  income  accounts 
in  what  may  be  called  narrative  form  as  distinguished  from  the 
account  form.  In  the  former  case  the  gross  sales  or  earnings  are 
stated,  deductions  are  made,  and  extraordinary  items  of  income 
are  added.  Thus  those  interested  are  enabled  to  read  the  state- 
ment as  a  continuous  story  of  what  has  been  done.  The  story  is 
unfolded  so  that  no  effort  is  required  and  no  calculation  need  be 
made  to  comprehend  each  step  and  the  final  result.  It  is  advis- 
able to  adopt  uniform  methods  whenever  feasible,  particularly 
when  comparisons  with  other  periods  and  other  businesses  are 
to  be  made,  but  form  must  be  subordinated  to  intelligent  use  and 
usability.  It  is  wise  to  depart  from  prescribed  forms  when  the 
story  can  be  told  better  by  the  use  of  differently  arranged  forms. 

The  account  form  contains  sales  or  gross  earnings  on  the 
credit  side  of  the  account,  and  costs,  expenses,  losses,  etc.,  on  the 
debit  side;  the  balance  is  brought  down  as  net  income  or  deficit. 
The  account  form  does  not  lend  itself  to  continuous  reading 
and  has  little  if  anything  to  recommend  it. 

The  auditor  should  direct  his  attention  to  the  contents  of 


292  AUDITING— GENERAL  PRINCIPLES 

the  income  account,  rather  than  to  its  form.  In  Chapter  XX  will 
be  found  examples  of  forms  most  commonly  used;  in  this  chapter 
the  discussion  is  limited  to  the  verification  which  must  be  made  of 
the  several  items  of  income  and  deductions  from  income  which 
appear  in  the  income  account. 

Proceeds  of  Sale  of  Treasury  Stock 

/  When  capital  stock  is  donated  to  corporations  the  proceeds 
of  sales  thereof  are  capital.  When  stock  is  purchased  in  the  open 
market  and  resold,  the  profit  or  loss,  if  any,  should  appear  in  the 
/  income  account.  There  is,  in  such  a  case,  virtually  no  difference 
'  between  dealing  in  its  own  stock  and  in  the  stocks  or  securities  of 
other  corporations.  It  has  been  urged  that  when  a  corporation 
purchases  part  of  its  stock,  it  is  a  capital  transaction  because 
its  outstanding  stock  is  reduced  and  its  surplus  increased  or 
decreased;  if  stock  is  purchased  below  par  surplus  is  increased; 
if  stock  is  purchased  above  par  surplus  is  reduced.  When  stock 
is  purchased  or  acquired  for  permanent  holding  or  for  formal 
reduction  of  outstanding  issues,  it  is  proper  to  treat  it  as  a  capital 
transaction;  but  when  a  corporation  buys  loo  shares  of  its  own 
stock  at  $80  a  share  and  immediately  sells  it  for  $90  a  share, 
the  gain  of  $1,000  is  no  more  a  capital  gain  than  if  the  pur- 
chase and  resale  were  of  any  other  security  or  commodity. 

Dividends  Must  Not  Be  Paid  from  Capital' 

Although  questions  regarding  capital  and  revenue  arise  in 
every  branch  of  accounts,  many  of  them  are  not  met  squarely, 
but  are  left  undecided.  Issue  is  not  usually  joined  until  the 
question  of  a  dividend  arises.  Directors  and  managers  who  will 
not  admit  that  depreciation  is  an  operating  expense,  nevertheless 


^  Under  federal  and  state  income  tax  practice,  the  entire  net  worth  of 
corporations  as  at  the  date  of  the  incidence  of  the  income  tax  laws  is  deemed 
to  be  capital.  In  effect  all  undistributed  earned  surplus  is  assumed  to  have 
been  capitalized.  The  distinction  is  important  from  the  standpoint  of  taxa- 
tion and  it  is  necessary  to  adjust  books  of  account  to  conform  thereto.  Ac- 
counting procedure  as  related  to  taxes  is  fully  discussed  in  the  author's  Income 
and  Excess  Profits  Tax  Procedure,  1921  editions. 


THE  INCOME  ACCOUNT  293 

hesitate  before  voting  for  or  advocating  the  payment  of  a  divi- 
dend before  sufficient  reserves  have  been  set  aside  to  maintain  the 
capital  intact. 

Authorities  Quoted. — Thomas  Conyngton,  in  his  book  on 
Corporate  Organization  and  Management ,  ^  says : 

Profits  are  the  only  proper  source  of  dividends.  The  declaration  of 
dividends  when  there  are  no  profits  is  contrary  to  law,  usually  involves  a 
personal  liability  by  the  parties  responsible,  and  in  many  states  involves  a 
criminal  liability  as  well.  If  an  illegal  dividend  is  contemplated,  any 
stockholder  may  enjoin  its  declaration  or  payment,  and,  should  the  com- 
pany become  insolvent,  the  stockholders  who  receive  such  dividends  may 
be  compelled  to  make  restitution. 

The  general  rule  in  this  country  is  that  before  dividends  can  be  prop- 
erly declared,  any  impairment  of  capital  through  business  losses  in  pre- 
vious years  or  through  depreciation,  must  first  be  made  good.  ^  In  other 
words,  dividends  must  be  declared  out  of  "surplus."  As  it  is  stated  in  a 
Missouri  case,  ''dividends  can  properly  be  declared  only  from  the  profits 
over  and  above  the  capital  stock  and  the  debts  of  the  company."  Before 
declaring  a  dividend  the  directors  should  examine  carefully  the  financial 
condition  of  the  company  and  the  statutory  provisions  regulating  the 
declaration  of  dividends  in  the  state  of  incorporation. 

Section  28  of  the  New  York  Stock  Corporation  Law  provides: 

The  directors  of  a  stock  corporation  shall  not  make  dividends,  except 
from  the  surplus  profits  arising  from  the  business  of  such  corporation,  nor  di- 
vide, withdraw,  or  in  any  way  pay  to  the  stockholders,  or  any  of  them,  any 
part  of  the  capital  of  such  corporation,  or  reduce  its  capital  stock,  except  as 
authorized  by  law.  In  case  of  any  violation  of  the  provisions  of  this  section, 
the  directors  under  whose  administration  the  same  may  have  happened, 
except  those  who  may  have  caused  their  dissent  therefrom  to  be  entered  at 
large  upon  the  minutes  of  such  directors  at  the  time,  or  were  not  present 
when  the  same  happened,  shall  jointly  and  severally  be  liable  to  such  cor- 
poration and  to  the  creditors  thereof  to  the  full  amount  of  any  loss  sus- 
tained by  such  corporation  on  its  creditors  respectively  by  reason  of  such 
withdrawal,  division,  or  reduction. 


2  Pages  399,  400. 

3  Of  course  impairment  of  capital  can  be  made  good  by  contributions  from 
stockholders. 


294  AUDITING— GENERAL  PRINCIPLES 

The  English  Companies  (Consolidation)  Act,  1908,  contains 
the  following  provisions  relative  to  dividends: 

Table  A.  Section  95.  The  company  in  general  meeting  may  declare 
dividends,  but  no  dividend  shall  exceed  the  amount  recommended  by  the 
directors. 

Section  96.  The  directors  may  from  time  to  time  pay  to  the  members 
such  interim  dividends  as  appear  to  the  directors  to  be  justified  by  the 
profits  of  the  company. 

Section  97.    No  dividend  shall  be  paid  otherwise  than  out  of  profits. 

There  is  no  material  difference  between  this  law  and  that  of 
New  York  State.  In  neither  jurisdiction  is  it  permissible  to  pay 
a  dividend  unless  the  capital  is  unimpaired.  Where  the  assets 
have  depreciated  in  value  and  the  depreciation  is  not  provided  for 
out  of  earnings,  the  capital  is  impaired. 

Case  of  Interborough-Metropolitan  Company. — The 
heavy  losses  of  the  Interborough-MetropoHtan  Company  of  New 
York  on  its  holdings  in  the  Metropolitan  Street  Railway  created 
a  very  large  deficit.  In  some  states  it  has  been  held  that  yearly 
profits  may  be  distributed  irrespective  of  shrinkage  in  capital 
assets,  but  in  New  York  the  question  has  not  been  judicially 
determined.  Although  the  current  income  of  the  Interborough- 
Metropolitan  Company  from  its  holdings  of  stock  of  profitable 
subsidiaries  had  been  large  enough  to  justify  dividends,  it  was 
considered  unwise  to  pay  dividends  so  long  as  the  large  deficit 
remained.  Thereupon  the  Interborough-MetropoHtan  Com- 
pany was  absorbed  by  a  new  company  which  had  a  much  smaller 
capitalization.  Upon  the  exchange  of  the  stock  of  the  old  com- 
pany for  that  of  the  new  company,  the  latter  immediately  com- 
menced the  payment  of  dividends. 

American  Malting  Case. — Many  corporations  exist  whose 

/  dividends  are  being  paid  or  have  been  paid  out  of  capital.     If 

stockholders  appreciated  their  rights,  many  directors  would  be 

called  to  account.     The  most  notable  example  of  this  practice  in 


(A 


J 


THE  INCOME  ACCOUNT  295 

the  United  States  is  the  American  Malting  case.  "*  If  an  auditor 
disagrees  with  a  board  of  directors  over  the  allocation  of  items 
to  capital  or  revenue,  he  may  find  it  salutary  to  request  them  to 
read  extracts  from  this  case. 

Contributed  Surplus. — Repayments  of  contributed  surplus 
are  not  dividends  but  distributions  of  capital.  Likewise,  distri- 
butions of  an  excess  secured  solely  by  reductions  of  capital  stock 
are  a  distribution  of  capital.  For  instance,  taking  a  corporation 
whose  assets  are  $250,000,  liabilities  $100,000,  and  capital  $300,- 
000,  there  would  be  a  deficit  of  $150,000.  Should  there  be  a 
reduction  of  capital  amounting  to  $200,000,  the  deficit  of  $150,000 
would  be  eliminated  and  a  surplus  of  $50,000  would  be  created. 
This  surplus  would  not  represent  surplus  profits  arising  from  the 
business,  and  a  distribution  of  such  surplus  could  not  be  con- 
sidered as  a  dividend. 

Wasting  Assets 

It  is  permissible  for  a  mining  company  to  pay  out  in  dividends 
all  realizations  from  its  operations,  but  its  stockholders  are  on 
notice  that  the  capital  of  the  company  is  being  dissipated.  On 
the  other  hand,  if  a  steel  company  owns  ore  lands  it  must  not 
treat  the  entire  proceeds  from  ore  sales  as  net  income,  but  is 
obliged  to  allocate  the  realizations  between  capital  and  income. 
The  capital  must  be  kept  intact  in  order  that  it  may  not  be  de- 
pleted.    The  net  income  may  be  distributed  in  dividends. 

Decedents'  Estates 

The  distinction  between  principal  and  income  is  even  more 
important  in  some  trust  estates  than  it  is  in  ordinary  commercial 
enterprises.  The  misapplication  of  an  item  may  affect  the  ultimate 
solvency  of  a  commercial  enterprise,  but  in  estate  accounting  the 
decision  of  a  court  as  to  whether  a  dividend  is  principal  or  income 
may  deprive  a  beneficiary  of  the  necessities  of  life. 


^Hutchinson  v.  Curtiss,  45  Misc.  Rep.  484;  92  N.  Y.  S,  70. 


296  AUDITING— GENERAL  PRINCIPLES 

For  a  full  discussion  of  the  questions  which  arise  in  the  audit 
of  the  accounts  of  decedents'  estates,  see  Volume  II. 

Importance  of  Uniform  Terminology  in  the  Income  Account 

Inspection  of  annual  reports  issued  during  192 1  by  many 
well-known  corporations,  containing  balance  sheets  and  income 
statements  prepared  and  certified  by  equally  well-known  public 
accountants,  proves  beyond  a  doubt  that  there  is  a  great  lack 
of  uniformity  in  terminology  regarding  the  items  of  income  and 
expenses.  At  one  time  the  author  beheved  that  the  trend  of  good 
accounting  practice  was  towards  the  term  ''profit  and  loss 
account";  but  at  the  present  time  the  use  of  other  terms  is  as 
frequent,  showing  that  there  was  no  tren4.Jn  any  direction — 
the  lack  of  uniformity  merely  continued.  (  The  terms  ''profits,'' 
"income,"  "revenue,"  and  "earnings"  are  used  synonymously  at 
times  and  at  other  times  a  distinction  is  drawn;  but  there  is  no 
uniformity  in  the  distinction,  so  that  it  increases  the  confusion 
to  differentiate.   1 

Comparing  Results. — One  result  of  the  lack  of  uniformity 
in  accounting  terminology  is  the  difficulty,  and  in  some  cases  the 
impossibility,  of  comparing  the  results  of  one  concern  with  those 
of  another.  In  a  banker's  circular  issued  in  May,  192 1,  reference 
was  made  to  the  finances  of  an  oil  company.  On  one  page  of  the 
circular  "net  earnings"  for  1920  were  stated  to  be  $35,000,000 
and  "income  available  for  surplus  and  reserves,"  $30,000,000. 
On  that  page  there  was  no  indication  that  depreciation  and 
depletion  had  not  been  provided  for,  but  on  another  page  "sur- 
plus income  after  depreciation"  appeared  as  $18,000,000.  The 
text  stated  that  "net  earnings  before  depreciation "  were  $30,000,- 
000.  The  audited  accounts  published  in  March  showed  "net 
earnings"  $35,000,000,  from  which  were  deducted  interest  and 
federal  taxes  $5,000,000,  leaving  "income  available  for  surplus 
and  reserves"  $30,000,000.  The  balance  sheet  (not  the  income 
statement)    contained   an   analysis  of   surplus   from   which  it 


THE  INCOME  ACCOUNT  297 

appeared  that  the  reserve  for  the  year  for  ^'depletion,  de- 
preciation, and  amortization"  was  $12,000,000,  but  the  item 
appeared  nowhere  else.  The  term  ^'income  available  for  surplus 
and  reserves"  would  not  as  a  rule  be  interpreted  to  mean  that 
depreciation  and  depletion  were  among  the  reserves  to  be  pro- 
vided for.  The  author's  impression  following  the  first  reading 
of  the  circular  was  that  the  net  income  greatly  exceeded  the 
amount  which  a  more  careful  reading  disclosed  to  be  the  actual 
net  income.  It  should  not  be  assumed  that  the  casual  investor 
is  a  careful  or  capable  analyst.  Bankers'  circulars  should  state 
actual  net  results;  if  there  are  extraordinary  deductions  they  can 
be  explained  in  the  text.  In  another  banker's  circular,  what 
purported  to  be  a  favorable  statement  was  supported  by  an 
income  statement  in  part  as  follows :  ^'  Net  income  after  depreci- 
ation; available  for  interest,  tax,  and  inventories  adjustments." 
The  items  excluded  obviously  were  substantial,  but  the  totals 
were  not  shown.  Failure  to  tell  the  whole  story  is  misleading 
to  investors  no  matter  how  excusable  the  intention  may  be. 

Net  Profits  versus  Net  Earnings. — The  term  *'  net  profits  " 
is  not  always  used  as  synonymous  with  ^'net  earnings."  In 
practically  all  cases  depreciation  is  deducted  before  arriving  at 
*'net  profits"  but  is  not  always  deducted  in  arriving  at  *'net 
earnings."  Therefore,  in  making  comparisons  it  is  not  feasible 
to  compare  the  ''net  earnings"  of  one  concern  with  the  ''net 
earnings"  of  another  even  though  they  are  engaged  in  the  same 
kind  of  business  and  are  audited  by  reputable  accountants.  It 
is  not  charged  that  attempts  are  being  made  to  mislead,  but  most 
laymen  find  it  difficult  to  understand  financial  statements  and 
they  should  not  be  further  confused  by  terms  to  which  different 
meanings  are  ascribed. 

Terms  to  Be  Employed. — Accountants  should  agree  on  terms 
which  describe  similar  items.  If  a  concern  "makes  money" 
after  allowing  for  all  accrued  costs  and  expenses,  the  net  result 
should  be  represented  by  one  term,  not  by  any  one  of  three  or 


V 


298  AUDITING— GENERAL  PRINCIPLES 

four.  The  author  had  an  open  mind  on  the  subject  and  was 
willing  to  adopt  a  term  which  is  most  frequently  used  by  leading 
accountants;  but  an  extensive  investigation  proved  that  no  term 
had  a  majority,  so  there  was  no  selection.  Driven  to  another 
method  of  selection,  the  author  decided  that  the  term  most  often 
used  by  the  Supreme  Court  of  the  United  States  might  be  satis- 
factory. It  is  a  logical  selection  because  income  and  profits  taxes 
are  based  on  the  distinction  between  capital  and  income.  It  is 
rather  foolish  to  struggle  over  the  distinctions  between  the  words 
*' profits,"  ^'earnings,"  and  '^revenue"  when  the  amount  to  be 
determined  must  immediately  be  referred  to  as  *'net  income." 
Is  it  not  logical  to  adopt  the  terms  ^'income  statement,"  "gross 
income,"  and  *'net  income,"  and  discard  all  other  terms  which 
mean  the  same  thing?  The  courts  for  centuries  have  differen- 
tiated between,  and  defined,  capital  and  income;  the  Sixteenth 
Amendment  to  the  Federal  Constitution  permits  Congress  to 
levy  taxes  upon  'incomes,  from  whatever  source  derived." 
Congress  has  passed  several  acts  imposing  taxes  upon  net  income 
and  provides  that  the  term  shall  include  ^' gains,  profits,  and  in- 
come." The  words  *'  earnings  "  and  ''  revenues  "  are  not  included, 
but  the  words  used  are  broad  enough  to  cover  all  income — no 
matter  what  it  may  be  called.  The  Supreme  Court  of  the  United 
States  has  decided  that  profits  derived  from  the  sale  of  capital 
assets  are  income  within  the  meaning  of  the  Sixteenth  Amendment 
to  the  Constitution.  If  it  is  of  great  importance  to  determine 
*'net  income"  for  tax  purposes,  why  not  simplify  accounting  pro- 
cedure and  define  the  term  for  general  use?  The  committee  on 
^  (  stock  list  of  the  New  York  Stock  Exchange,  in  its  published  re- 
quirements for  original  listing,  uses  the  term  ''income  account." 

The  accounting  distinction  between  capital  and  income  is 
not  affected  by  tax  legislation.  It  is  possible  and  proper  that  a 
different  rate  of  tax  should  be  imposed  upon  capital  gains  and 
net  income.  The  probability  of  such  a  distinction  in  a  tax 
measure  merely  emphasizes  the  importance  of  differentiating 
between  the  two  in  books  of  account  and  published  statements. 


THE  INCOME  ACCOUNT  299 

The  use  of  the  term  "  gross  income  "  for  gross  sales  and  operat- 
ing revenues  (gross)  offers  some  difficulties;  for  example: 

U.  S.  Treasury  includes  in  *' gross  income"  the  excess  of 
gross  sales  over  cost  of  goods  sold.^ 

Interstate  Commerce  Commission  uses  "gross  income"  as 
the  aggregate  of  operating  income  (operating  revenues 
less  operating  expenses  and  taxes)  and  non-operating 
income.  It  is  the  item  immediately  preceding  the 
"deductions"  for  rentals  and  interest. 

Definition  of  " Gross  Income." — The  term  "gross  income" 
means  accruals  (as  distinguished  from  cash  receipts)  from  all 
sources,  such  as  sales,  rentals,  and  interest;  profits  derived  from 
the  sale  of  capital  assets,  and  the  excess  of  previously  created 
reserves  over  the  ascertained  needs  for  such  reserves. 

The  term  should  be  divided  into  three  parts : 

1.  Current  gross  income,  to  be  called  "operating  income"  or 
by  any  similar  title.  Current  gross  income  includes:  gross  sales, 
which  means  all  sales  delivered  or  to  which  title  has  passed 
to  the  vendees,  from  which  there  have  been  deducted  returned 
goods  or  goods  to  be  returned,  trade,  quantity,  and  similar  dis- 
counts, and  all  allowances  which  would  have  been  deducted  from 
the  sales  prices  if  known  at  time  of  invoicing,  such  as  those  due 
to  changes  in  prices,  damaged  goods,  and  shortages. 

2.  Gross  income  accrued  or  realized  from  other  sources,  such 
as  dividends,  interest,  profits  arising  from  sale  of  capital  assets, 
surplus  reserves  and  extraordinary  items  affecting  prior  periods. 

3.  Unrealized  income,  if  any,  arising  from  increment  in  values 
from  undelivered  sales  or  similar  sources.  Provision  for  this 
group  does  not  carry  with  it  any  implication  that  unrealized 
appreciation  should  be  carried  to  the  income  account.  The  chief 
reason  for  the  grouping  is  that  in  some  industries  and  in  some 
concerns  the  practice  is  more  or  less  common.     If,  as  and  when  it 


5  See  Form  1120. 


300  AUDITING— GENERAL  PRINCIPLES 

is  found  the  amounts  must  be  segregated  and  not  included  in 
groups  (i)  or  (2). 

From  (i)  above  may  be  deduced  the  following  definitions; 
the  term  "gross  sales"  means  the  aggregate  value  of  the  goods  or 
services  delivered  or  rendered  within  a  given  period,  without 
regard  to  the  collection  of  the  proceeds;  the  term  "net  sales" 
means  gross  sales  less  any  deductions  for  returns,  allowances,  or 
discounts  in  excess  of  2  per  cent.  Losses  arising  from  bad  debts, 
or  reserves  therefor,  are  not  included  among  such  deductions  buf 
should  appear  as  a  separate  item  following  administrative  ex- 
penses. Allowances  which  are  of  the  nature  of  compromises  and 
which  are  not  recognized  as  valid  claims  (when  it  is  possible  to 
draw  the  distinction)  should  not  appear  among  the  deductions 
but  should  be  included  in  either  sales  or  administrative  expenses, 
depending  upon  the  nature  of  the  deduction. 

Collections  for  Fire  Losses. — If  amounts  collected  for  fire 
losses  have  been  included  in  the  sales,  such  items  should  be 
excluded  and  proper  entries  made  through  the  purchase  accounts 
instead,  since  the  fire  loss  is  in  many  respects  equivalent  to  return 
of  the  merchandise.  If  the  amount  received  from  the  insurance 
company  is  either  more  or  less  than  the  cost  of  the  goods,  the 
difference  should  be  passed  through  the  income  account  as  a 
separate  item. 

Definition  of  Net  Income. — The  term  "net  income"  means 
the  balance  of  income  remaining  after  deducting  from  gross 
income  all  costs,  charges,  and  expenses  (including  items  ac- 
crued but  not  paid  and  losses  arising  from  the  sale  of  capital 
assets). 

The  deductions  from  gross  income  should  be  divided  into 
classes: 

I.  Current  charges  against  income,  such  as  cost  of  goods; 
cash  discounts;  allowances  not  fairly  deductible  from 
sales  prices;  selling,  general,  and  administrative  expens- 


THE  INCOME  ACCOUNT  301 

es;  bonuses  to  officers  and  employees;^  bad  accounts 
and  reserves  for  doubtful  accounts;  adequate  depre- 
ciation (when  not  included  in  cost  of  goods),  depletion 
and  ordinary  obsolescence  (if  there  is  such  a  thing); 
insurance;  proportion  of  deferred  charges  carried  over 
as  applicable  to  the  current  period  (if  not  absorbed 
— as  they  should  be — in  the  accounts  to  which  they 
relate);  property  and  similar  taxes  paid,  accrued  or 
estimated;^  and  any  other  charges  and  expenditures 
properly  chargeable  to  current  operations. 

2.  Deductions  from  gross  income  for  interest  paid  and  ac-' 

crued  on  borrowed  money  (but  not  interest  on  capital), 
federal  and  state  income  taxes,  accrued  or  estimated. 

3.  Losses  arising  from  sale  of  capital  assets,  and  other 

extraordinary  items  affecting  prior  periods. 

Taxes. — The  deductions  shown  under  (2)  should  include 
all  income  taxes.  A  New  York  corporation  cannot  claim  to  have 
accumulated  any  net  income  in  any  year  until  provision  is  made 
for  taxes  accrued  or  payable  to  the  United  States  and  to  New 
York  State,  based  on  net  income  for  the  same  year.  It  is  true 
that  federal  taxes  are  based  on  ^'net  income,"  but  the  taxes  are 
based  on  net  income  before  federal  taxes;  the  net  income  which 
remains  after  taxes  is  the  true  net  income  of  the  business.  The 
term  *'net  income,"  when  used  without  qualification,  means  what 


^  When  an  employee  is  entitled,  under  contract,  to  a  share  in  the  net 
income  of  a  concern,  the  contract  should  define  the  term  "net  income"  so  far 
as  doubtful  items  are  concerned.  These  doubtful  items  are  interest  on  capital, 
reasonable  salaries  to  the  owners,  depreciation,  depletion,  obsolescence,  and 
income  and  profits  taxes.  If  the  term  is  not  defined  in  the  contract,  good 
accoimting  practice  would  be  deemed  to  permit  the  deduction  from  net  income 
of  reasonable  depreciation  and  other  reserves,  salaries,  but  not  interest  on 
capital  or  income  or  profits  taxes.  It  is  entirely  proper  to  specify  in  a  contract 
that  income  taxes  and  interest  shall  be  deducted  before  net  income  is  deter- 
mined, but  if  the  provision  is  not  made  the  employee  is  entitled  to  the  benefit 
of  the  doubt.  The  exclusion  of  profits  taxes  is  somewhat  arbitrary;  but  an 
item  which  varies  in  a  few  years  from  nothing  to  80  per  cent,  cannot  be  dealt 
with  as  an  ordinary  expense  of  the  business,  it  is  payable  only  on  what  remains 
after  an  allowance  is  made  for  a  so-called  reasonable  return  on  invested  capital. 

7  See  page  330  for  discussion  of  this  point. 


302  AUDITING— GENERAL  PRINCIPLES 

is  left  for  the  stockholders  from  the  operation  of  a  business. 
The  argument  cannot  successfully  be  sustained  that  there  would 
be  any  net  income  accruing  to  a  corporation  until  all  taxes,  includ- 
ing federal  taxes,  were  deducted.  This  principle  holds  good 
whether  or  not  the  taxes  or  other  charges  have  been  paid. 

If  the  deductions  exceed  the  gross  income,  the  balance  should 
be  called  the  net  loss  or  deficit  for  the  period.  The  term  ''net 
loss  "  is  often  appHed  to  specific  losses  as  well  as  to  losses  for  entire 
fiscal  years;  therefore  the  term  ''deficit"  is  more  descriptive,  but 
it  is  not  in  general  use. 

Treatment  of  Net  Income. — It  is  proper  to  show  deductions 
from  gross  income,  but  there  should  be  no  deductions  from  net 
income  except  extraordinary  items  of  substantial  amounts  which 
have  no  relation  to  the  current  period;  every  effort  should  be 
made  to  avoid  this  class  of  deductions.  The  amount  of  net 
income  should  be  transferred  to  surplus.  No  charges  should 
appear  in  surplus  except  charges  for  dividends  and  deficits,  and 
no  credits  except  credits  for  net  income. 

Blue-Sky  Laws.— Many  of  the  so-called  "Blue-Sky"  laws  of 
the  various  states  stipulate  that  the  net  income  of  the  corpora- 
tions whose  securities  are  to  be  offered  must  equal  a  stated  mini- 
mum. The  provisions  are  general  in  their  nature  and  will  be 
interpreted  according  to  good  accounting  practice.  The  inten- 
tion is  practically  the  same  in  each  law,  but  there  is  no  uniformity 
in  terminology.  Terms  frequently  used  are:  a  fair  return;  net 
profits;  net  earnings;  earning  power;  gross  income,  less  expenses 
and  fixed  charges;  receipts  and  disbursements;  gross  and  net 
earnings,  actual  or  estimated;  a  profit;  earnings. 

The  foregoing  terms  will  be  construed  more  or  less  strictly; 
therefore  the  intention  of  the  legislators  may  be  frustrated 
because  they  use  terms  which  probably  will  be  interpreted  to 
mean  something  different  from  that  intended.  The  use  of  the 
terms  "gross  income"  and  "net  income"  would  accomplish  the 
intended  result  in  every  case. 


THE  INCOME  ACCOUNT  303 

Importance  of  Income  Account 

A  balance  sheet  audit  is  only  partially  completed  with  the  veri- 
fication of  the  assets  and  liabiHties.  The  income  account  supple- 
ments the  balance  sheet  and  reflects  the  changes  that  occur  in  the 
real  accounts  during  the  accounting  period.  It  follows  that  a  thor- 
ough balance  sheet  audit  cannot  be  made  unless  due  attention  is 
paid  to  those  accounts  which  are  periodically  closed  into  profit  and 
loss,  and  which  afford  data  for  constructing  the  income  account. 

At  least  nine-tenths  of  all  the  enterprises  with  which  a  pro- 
fessional auditor  has  to  deal  are  conducted  with  the  expectation 
of  realizing  a  profit.  Certainly  more  than  half,  and  probably 
three-fourths,  of  these  enterprises  have  their  accounts  stated  and 
results  shown  in  a  form  to  which  a  professional  auditor  cannot 
certify  without  modification  or  adjustment.  That  is  to  say,  most 
concerns  state  their  income  accounts  incorrectly. 

In  view  of  the  fact  that  there  is  scarcely  any  likeHhood  that 
two  professional  auditors  today  would,  with  respect  to  thai 
accounts  of  an  undertaking  of  any  considerable  magnitude,  show 
the  same  net  result  of  profit,  it  is  nOt  surprising  that  the  usual 
income  account  is  prepared  upon  a  basis  which  admits  of  criticism. 
It  is  extremely  important  that  an  effort  be  made  to  estabHsh 
standards  which  will  appeal  to  those  responsible  for  the  stating 
of  accounts  as  scientific  and  reasonable.  The  latter  term  may 
seem  out  of  place,  but  it  must  be  understood  that  rules  which  are 
purely  theoretical  will  not  be  observed. 

It  is  not  enough  to  know  that  the  net  income  or  deficit  for 
a  particular  period  is  a  certain  sum.  All  who  are  interested  in 
the  enterprise  desire  to  know  the  particulars  of  the  net  result,  and 
the  auditor  who  states  the  transactions  in  an  intelligent,  scientific, 
readable  way  is  the  one  who  finds  favor  with  business  men. 
The  auditor  who  familiarizes  himself  with  the  legal  as  well  as  the 
economic  aspects  of  income  and  expense  accounts  is  best  prepared 
to  analyze  accounts  properly  and  to  present  the  results  so  that 
the  relation  of  certain  figures  or  groups  of  figures  will  convey  all 
that  they  should  convey. 


304  AUDITING— GENERAL  PRINCIPLES 

Relation  of  Net  Income  to  Price-Fixing 

There  is  a  decided  trend  towards  price-fixing  by  governmental 
bodies.  For  many  years  it  has  been  recognized  that  public 
utilities,  being  in  the  nature  of  monopolies,  may  properly  be 
limited  to  a  fair  return  on  capital  invested.  Unfortunately, 
hostile  and  demagogic  politicians  have  destroyed  the  attitude  of 
fairness  which  should  characterize  the  treatment  of  corporations 
which  furnish  service  to  the  public.  Power  is  inherent  in  the 
legislature  to  reduce  exorbitant  rates,  but  permission  should  be 
given  to  raise  rates  when  costs  of  operation  increase. 

Price-Fixing  Tendencies. — Government  power  to  regulate 
has  been  extended  in  some  states  (and  by  Congress  in  the  District 
of  Columbia)  to  rents  and  to  the  necessities  of  life.  Here,  too,  the 
regulation  is  one-sided;  when  so-called  profiteering  is  charged, 
prices  are  arbitrarily  reduced;  when  prices  are  below  cost  no 
remedial  measures  are  suggested. 

In  1920  many  sugar  companies  were  charged  with  making 
unconscionable  profits;  in  192 1  all  companies  were  compelled  to 
sell  below  cost.  Labor  unions  have  suggested  that  wages  be 
based  on  profits,  and  the  proposition  seems  fair  enough;  but 
when  labor  unions  have  had  any  say  they  have  insisted  that  prices 
be  unduly  increased  so  that  wages  could  be  inflated. 

Inequalities  in  Price-Fixing. — During  the  World  War  it 
was  necessary  to  fix  the  prices  of  those  commodities  for  which  the 
demand  was  greater  than  the  supply,  in  order  to  prevent  runaway 
markets.  In  all  of  the  foregoing  cases  the  basic  questions  were, 
"What  fair  and  reasonable  net  income  is  an  industry  entitled  to?  " 
and,  *'What  prices  produce  such  fair  net  income?"  In  a  vast 
number  of  cases  neither  question  was  satisfactorily  answered 
because  trustworthy  statements  of  net  income  were  not  available. 
In  many  cases  the  lack  of  trustworthy  statements  was  due  to 
faulty  accounts;  in  more  cases  the  failure  was  due  to  an  as- 
tounding lack  of  uniformity  in  the  presentation  of  financial  re- 


THE  INCOME  ACCOUNT  305 

suits.  ^  Who  IS  to  blame?  The  truth  of  the  matter  is  that,  outside 
of  regulated  concerns  such  as  public  utilities  and  a  few  industries 
which  have  adopted  uniform  income  accounts,  the  proposition  of 
income  accounts  is  a  hit-or-miss  (usually  miss)  affair  in  which 
the  personal  inclinations  of  those  responsible  for  them  play  the 
most  prominent  part. 

There  has  been  little  improvement  in  this  respect  during 
the  last  ten  years.  It  is  true  that  depreciation  is  now  provided  j 
for  more  than  formerly;  but  it  required  high  tax  rates  to  influence  J 
many  concerns.  There  must  be  more  general  agreement  on  the 
meaning  of  the  term  "net  income"  or  public  sentiment  which  is 
now  running  against  governmental  price-fixing  will  react  in  its 
favor.  If  business  concerns  do  not  set  their  accounts  in  order 
and  render  periodical  statements  which  unequivocally  show  true 
net  income  so  that  anyone  reasonably  familiar  with  accounts  can 
compare  one  concern  with  another,  and  the  net  income  of  all 
representative  concerns  in  any  industry,  it  is  quite  possible  that 
restrictive  and  annoying  legislation  will  be  passed  which  will 
require  the  publication  of  uniform  statements. 

Legal  Definition  of  Net  Income 

The  courts  in  various  jurisdictions  have  defined  "income,'' 
"net  income,"  and  "net  profits"  available  for  dividends,  in  so 
many  ways  that  an  auditor  or  corporate  officer  who  desires 
authority  for  any  position  which  he  wishes  to  assume  can  usually 
find  it  in  the  law  reports. 

Courts  have  held  that  a  dividend  may  be  declared  out  of  the  net 
income  of  one  year  although  a  large  deficit  is  carried  over  from  pre- 
vious years ;  they  have  also  held  that  * '  past-due  floating  debt  should 
be  paid  or  funded  before  a  dividend  is  declared."  Nearly  every 
conceivable  situation  between  these  extremes  has  been  held  to  be 
both  legal  and  illegal,  depending  on  the  judge  deciding  the  case. 


*  The  author  was  a  member  of  the  general  price-fixing  committee  of  the 
War  Industries  Board.  This  statement  is  based  on  his  personal  inspection  of 
thousands  of  income  accounts  submitted  as  bases  for  price-fixing. 


'O 


VOL.  I — 20 


306  AUDITING— GENERAL  PRINCIPLES 

Cases  Cited. — In  many  decisions  net  income  is  defined  and 
the  ludicrous  definitions  and  comments  in  themselves  explain 
why  it  is  that  the  courts  vary  to  such  a  great  extent  in  settling 
disputes  which  involve  accounts.  The  fact  is  that  judges,  who 
are  trained  as  lawyers,  understand  as  little  about  accounts  as  do 
the  members  of  the  bar.  The  adage,  ''A  little  knowledge  is  a 
dangerous  thing,"  has  its  exemplification  in  the  treatment  by 
lawyers  of  questions  of  accounting.  They  have  the  temer- 
ity to  settle  matters  of  the  greatest  importance,  involving  com- 
plicated accounts,  without  any  evidence  that  anyone  who 
understands  accounts  has  been  consulted  in  the  settlement. 
Occasionally  the  departure  from  the  usual  legal  comment  is  so 
great  that  it  is  worth  placing  on  record.  The  court  said  in  one 
case: 

If  at  the  end  of  the  first  year  the  line  of  railway  is  still  in  so  good  a  state  of 
repair  that  it  requires  nothing  to  be  laid  out  on  it  for  repairs  in  that  year, 
still,  before  you  can  ascertain  the  net  profits,  a  sum  of  money  ought  to  be 
set  aside  as  representing  the  amount  in  which  the  wear  and  tear  of  the  line 
has,  I  may  say,  so  far  depreciated  it  in  value  that  that  sum  will  be  required 
for  the  next  year  or  next  two  years.  I  should  think  no  commercial  man 
would  doubt  that  this  is  the  right  course — that  he  must  not  calculate  net 
profits  until  he  has  provided  for  all  the  ordinary  repairs  and  wear  and  tear 
occasioned  by  his  business.  That  being  so,  it  appears  to  me  that  you  can 
have  no  net  profits  unless  this  sum  has  been  set  aside.  When  you  come  to 
the  next  year,  or  the  third  or  fourth  year,  what  happens  is  this:  as  the  line 
gets  older  the  amount  for  repairs  increases.  If  you  had  done  what  you 
ought  to  have  done,  that  is,  set  aside  every  year  the  sum  necessary  to 
make  good  the  wear  and  tear  in  that  year,  then  in  the  following  years  you 
would  have  a  sum  sufficient  to  meet  the  extra  cost. 

The  following  definitions  are  taken  from  the  decisions  of 
federal  courts: 

It  (income)  must,  by  certain  attributes,  be  distinguished  out  of  the 
mass,  or  from  other  things  with  which  it  is  compared  ....  Receipts 
and  accumulations  of  a  business  corporation  are  of  two  classes:  one,  those 
which  constituted  its  gross  income;  and  the  other  those  which  represented 
the  sale  or  conversion  of  its  capital,  and  the  controversy  has  always  been 


THE  INCOME  ACCOUNT  30? 

as  to  the  respective  definitions  of  those  two  classes.    We  accept  this  as  the 
rightful  criterion.^ 

The  meaning  of  that  word  (income)  is  not  to  be  found  in  its  bare  ety- 
mological derivation.  Its  meaning  is  rather  to  be  gathered  from  the  im- 
plicit assumptions  of  its  use  in  common  speech.  The  implied  distinction, 
it  seems  to  us,  is  between  permanent  sources  of  wealth  and  more  or  less 
periodic  earnings.  Of  course  the  term  is  not  limited  to  earnings  from  eco- 
nomic capital;  i.e.,  wealth  industrially  employed  in  permanent  form.  It 
includes  the  earnings  from  a  calling,  as  well  as  interest,  royalties,  or  divi- 
dends, though  in  the  case  of  corporations  this  may  be  of  slight  importance.  ^  ° 

"Net  income"  imports  a  ''gross  income,"  and  the  difference  between 
the  two  implies  the  expenditure  of  income  for  some  corporate  purpose, 
as  that  of  ''carrying  on  or  doing  (the)  business"  for  which  the  corporation 
is  organized.  ^  ^ 

We  must  reject  in  this  case  .  .  .  the  broad  contention  ....  that 
all  receipts — everything  that  comes  in — are  income  within  the  proper 
definition  of  the  term  "gross  income,"  and  that  the  entire  proceeds  of  a 
conversion  of  capital  assets,  in  whatever  form  and  under  whatever  circum- 
stances accomplished,  should  be  treated  as  gross  income.  ^^ 

"Net  income,"  of  course,  means  gross  income  after  deducting  all  outgo 
necessarily  incident  to  the  business.  ^^ 

Whatever  difficulty  there  may  be  about  a  precise  and  scientific  defini- 
tion of  "income,"  it  imports,  as  used  here,  something  entirely  distinct 
from  principal  or  capital  either  as  a  subject  of  taxation  or  as  a  meas- 
ure of  the  tax;  conveying  rather  the  idea  of  gain  or  increase  arising 
from  corporate  activities.  As  was  said  in  Stratton's  Independence  v.  How- 
bert,  231  U.  S.  399,  415;  58  L.  Ed.  285,  292;  34  Sup.  Ct.  Rep.  136:  "In- 
come may  be  defined  as  the  gain  derived  from  capital,  from  labor,  or  from 
both  combined." 

Understanding  the  term  in  this  natural  and  obvious  sense,  it  cannot  be 
said  that  a  conversion  of  capital  assets  invariably  produces  income.  If 
sold  at  less  than  cost,  it  produces  rather  loss  or  outgo.    Nevertheless,  in 


9  Denison,  Circuit  Judge,  in  Biwabik  Mining  Co.  v.  U.  S.,  242  Fed.  9. 

^*»  Learned  Hand,  District  Judge,  in  U.  S.  v.  Oregon-Wash.  R.  &■  Nav.  Co., 
251  Fed.  211. 

"  WooUey,  Circuit  Judge,  in  Lewellyn  v.  Pittsburgh,  B.  &  L.  E.  R.  Co.,  222 
Fed.  177;  137  C.  C.  A.  617. 

^*  Mr.  Justice  Pitney,  in  Southern  Pacific  Company  v.  Lowe,  247  U.  S.  330; 
62  L.  Ed.  1142. 

'3  Holt,  District  Judge,  in  Forty-Two  Broadway  Co.  v.  Anderson,  209  Fed. 
991. 


308  AUDITING— GENERAL  PRINCIPLES 

many  if  not  in  most  cases  there  results  a  gain  that  properly  may  be  ac- 
counted as  a  part  of  the  ''gross  income"  received  ''from  all  sources"; 
and  by  applying  to  this  the  authorized  deductions  we  arrive  at  "net  in- 
come." In  order  to  determine  whether  there  has  been  gain  or  loss,  and  the 
amount  of  the  gain,  if  any,  we  must  withdraw  from  the  gross  proceeds  an 
amount  sufficient  to  restore  the  capital  value  that  existed  at  the  com- 
mencement of  the  period  under  consideration.^"* 

Economic  Definition  of  Net  Income 

In  discussing  profits  the  Encyclopedia  of  Accounting  states 
that  from  an  economist's  point  of  view  profit  consists  of  the  sur- 
plus remaining  over  from  the  employment  of  capital  after  defray- 
ing all  the  necessary  expenses  and  outlays  incurred  in  its 
employment,  and  after  the  capital  has  been  replaced  or  provision 
made  for  its  replacement.  If  there  are  not  sufficient  assets  left  to 
replace  the  capital,  the  result  of  the  venture  or  employment  is  a 
loss  and  the  amount  by  which  the  capital  is  diminished  is  the 
measure  of  this  loss.  Profits  are  arrived  at  by  means  of  balance 
sheets  which  show  the  true  financial  position  of  the  concern, 
supplemented,  where  the  books  are  properly  kept,  by  an  income 
account. 

For  example,  the  profit  of  a  company  for  the  first  year  is  the 
excess  of  assets  over  liabilities  (including  in  the  latter  the  paid 
up  capital),  while  there  are  exhibited  in  the  income  account 
the  sources  from  which  the  profits  have  arisen.  The  profit  for 
any  period  is  the  increase  in  the  excess  of  assets  over  liabiHties  at 
the  end  of  the  year,  as  compared  with  the  excess  of  assets  over 
liabilities  at  the  beginning  of  the  year. 

Accountant's  Definition  of  Net  Income 

If  a  public  accountant  were  asked  to  define  the  term  ''net 
income,"  he  would  probably  reply :  ''The  net  income  of  a  business 
is  the  surplus  remaining  from  the  earnings  after  providing  for  all 
costs,  expenses,  and  reserves  for  accrued  or  probable  losses." 


■4  Mr.  Justice  Pitney,  in  Doyle  v.  Mitchell  Bros.  Co.,  247  U.  S.  179. 


THE  INCOME  ACCOUNT  3^9 

Capital  versus  Revenue. — There  are  capital  profits  and 
revenue  profits.  Thus,  for  instance,  part  of  a  tract  of  land  upon 
which  a  factory  has  been  erected  is  sold  for  an  amount  equal  to 
the  original  cost  of  the  entire  undertaking.  This  is  realized 
income,  but  it  does  not  fall  within  the  ordinary  definition,  there- 
fore it  is  not  wise  to  rely  exclusively  upon  any  one  definition.  The 
net  income  from  a  man's  vocation  is  revenue  profit;  the  net  profit 
realized  from  an  outside  venture  is  capital  profit. 

Net  Income. — As  stated  on  page  278,  the  author  believes 
that  the  word  '^  surplus,"  other  than  capital  surplus  and  the 
surplus  of  banks,  should  be  used  only  to  designate  an  amount 
available  for  dividends.  The  term  ^'net  income"  should  be  used 
only  to  designate  the  amount  arrived  at  by  stating  the  income 
actually  accrued  during  a  stated  period,  collected  or  collectible, 
less  the  cost  thereof  actually  paid,  and  less  further  costs  accrued 
but  not  paid,  such  as  depreciation,  obsolescence,  taxes,  and  other 
charges  apportioned  against  the  income,  such  as  reserves  for 
strikes,  workmen's  pensions,  etc.  Reserves  for  working  capital, 
unknown  contingencies,  etc.,  are  not  costs,  but  reservations  of 
profits,  and  so  are  not  to  be  considered  in  determining  net  income. 
If  absolutely  accurate  balance  sheets  could  be  prepared  at  the 
beginning  and  at  the  end  of  a  period,  the  difference  between  their 
surplus  accounts  (withdrawals,  dividends,  and  reservations  being 
considered)  would  represent  the  net  income  or  deficit  for  the  term; 
but  the  valuation  and  revaluation  of  capital  assets  involves  too 
much  speculation  to  permit  the  recognition  of  such  practice  as 
satisfactory.  This,  in  effect,  is  the  method  used  to  secure  results 
in  single  entry,  but  its  utter  failure  to  justify  itself  is  reason 
enough  for  abandoning  it. 

Expenses  Omitted. — ^A  business  man  wants  to  know  his  gross 
earnings  for  the  year,  also  all  of  the  costs  and  expenses  which  are 
properly  chargeable  thereto.  Naturally  the  net  result,  whether  a 
profit  or  a  loss,  coincides  with  the  changes  in  the  balance  sheet  at 
the  beginning  and  the  end,  exclusive  of  capital  receipts  or  expendi- 


3IO  AUDITING— GENERAL  PRINCIPLES 

tures  during  the  period.  But  the  business  man  does  not  always 
think  that;  sometimes  he  wants  to  have  the  gross  earnings  stated 
and  to  have  made  as  few  deductions  therefrom  as  possible,  in 
order  to  show  favorable  results.  He  may  be  willing  to  create  a 
reser\^e  for  depreciation  on  the  books  and  in  the  iacome  tax 
returns,  but  he  does  not  always  want  it  to  appear  in  the  statement 
which  he  shows  his  banker.  He  does  not  consider  that  the  income 
account,  as  he  would  state  it,  taken  in  connection  with  his  balance 
sheets,  would  be  inaccurate  on  its  face.  The  professional  auditor, 
however,  is  imder  a  much  greater  responsibility.  He  cannot 
afford  to  prepare  an  income  account  which  omits  any  material 
item.  Just  what  should  be  iacluded  and  what  excluded  will  now 
have  our  attention. 


CHAPTER   XVI 
THE  INCOME  ACCOUNT— REVENUES 

In  a  balance  sheet  audit  it  is  not  expected  that  the  auditor 
will  attempt  to  certify  that  all  of  the  gross  income  for  any  period 
which  should  have  been  accounted  for  has  been  accounted  for. 
The  verification  of  the  income  account  can  hardly  extend  be- 
yond tests  and  scrutiny  which  consist  largely  of  analyses  and 
comparisons.  The  segregation  of  gross  income  into  appropriate 
classes  and  the  relation  of  the  classes  to  previous  results,  to  costs, 
and  to  net  income  is  a  comparatively  simple  task  when  accounts 
are  well  kept.  Unusual  or  suspicious  results  demand  further 
investigation.  When  accounts  are  not  well  kept  or  when  the 
internal  audit  is  inadequate,  the  auditor  must  remind  the  client 
of  the  limitations  of  a  balance  sheet  audit  so  far  as  the  income 
account  is  concerned. 

In  this  chapter  will  be  discussed  a  few  income  account  matters 
which  require  attention  in  balance  sheets  audits. 

Gross  Income 

It  is  customary  and  desirable  to  show  the  gross  business 
transacted,  whether  arising  from  sales  of  goods,  or  from  sersdces 
rendered  by  professional  men  and  others,  or  by  public  service 
corporations  or  similar  enterprises. 

Retiims 

Where  earnings  arise  from  the  delivery  of  goods  and  for  any 
reason  the  goods  are  returned,  the  aggregate  returned  is  usually 
deducted  from  the  gross  income  before  stating  same.  The  reason 
for  this  is  that,  if  the  goods  are  returned  and  credited  at  the  same 
price  at  which  charged,  and  are  available  for  resale,  it  is  improper  to 
augment  the  sales  by  transactions  never  consummated,  thus  render- 

3" 


312  AUDITING— GENERAL  PRINCIPLES 

ing  the  calculations  of  gross  profits,  etc. ,  less  valuable.  This  is  the 
general  rule,  but  if  it  is  desired  to  have  the  returned  sales  shown  as  a 
deduction  from  the  gross  sales,  there  is  no  objection  to  such  proce- 
dure. It  may  be  of  interest  as  a  means  of  showing  whether  or  not 
the  proportion  of  returns  to  the  total  volume  of  business  is  proper. 

Returns  and  Falling  Prices. — In  verifying  income  from 
sales  the  auditor  is  chiefly  concerned  with  the  possibility  of  the 
return  of  shipments  made  immediately  before  the  date  of  the  bal- 
ance sheet.  In  a  time  of  falling  prices  the  point  is  an  important 
one  because  buyers  do  not  hesitate  to  return  goods  which  have 
been  ordered  and  shipped  under  firm  contracts.  Even  though 
goods  have  been  returned  and  accepted,  the  buyer  is  not  released 
unless  the  seller  acquiesces  in  the  transaction;  if  the  right  to 
return  is  questioned  the  legal  position  of  the  seller  is  quite  as 
strong  as  if  delivery  from  the  transportation  company  were 
refused.  It  is  an  unnecessary  expense  to  leave  goods  in  the 
hands  of  carriers  pending  the  settlement  of  disputes. 

Sales  of  Consigned  Goods 

The  profit  on  goods  sold  to  consignees  is  income  to  the  con- 
signor for  the  period  in  which  the  sales  are  made,  even  though 
consignors  do  not  receive  notices  of  sales  until  subsequent  periods. 

Ordinary  Transactions  Only  to  Be  Included 

It  should  be  noted  that  the  only  earnings  which  should  be 
shown  in  the  first  division  of  the  income  account  are  those  which 
are  incident  to  the  normal  operation  of  the  business.  All  other 
earnings  should  be  excluded  from  this  division.  This  should  be 
done  because  the  relation  of  one  account  to  another,  both  for 
immediate  observation  and  for  future  comparative  purposes, 
must  be  expressed  in  percentages  and  amounts  and  because  the 
inclusion  of  any  item  outside  the  ordinary  scope  of  the  enterprise 
affects  these  percentages  and  amounts  and  thus  diminishes  their 
value  for  purposes  of  comparison. 


THE  INCOME  ACCOUNT— REVENUES  313 

Allowances  and  Rebates 

These  are  the  next  deductions  and  are  also  direct,  except  that 
separate  ledger  accounts  should  be  kept  therefor,  unless  the  items 
are  few  in  number  and  small  in  amount.  Whenever  the  aggre- 
gate is  a  material  percentage  of  the  gross  sales,  and  therefore 
subject  to  comment'  and  possible  criticism,  it  should  be  shown  on 
the  statement. 

It  is  not  always  easy  to  determine  the  distinction  between 
allowances  which  represent  true  deductions  from  gross  sales  and 
those  which  should  be  included  among  costs  or  expenses.  In  the 
retail  automobile  business  it  is  customary  to  accept  used  cars  in 
part  payment  for  new  cars.  The  used  cars  usually  realize  less 
than  their  nominal  cost.  On  the  face  of  the  transaction  the 
dealer  sells  a  new  car  for  $3,000,  allows  $1,000  on  a  used  car,  and 
collects  $2,000  in  cash.  He  sells  the  used  car  for  $800.  Under 
good  accounting  practice,  the  apparent  loss  of  $200  (plus  expenses 
of  resale)  should  be  shown  as  a  deduction  from  the  gross  sales 
price  of  the  new  car,  rather  than  as  a  loss  arising  from  the  sale  of  a 
used  car. 

Doubtful  Accounts 

The  earnings  just  referred  to  are  gross  and  are  so  stated 
whether  or  not  they  are  realized  in  cash  or  its  equivalent.  The 
question  arises  as  to  whether  an  allowance,  or  reserve,  for  doubtful 
or  bad  accounts  should  be  considered  at  this  stage  and  be  deducted 
direct  from  the  gross  earnings,  or  whether  it  should  be  treated  as 
an  expense  of  administration  or  selling  and  be  included  in  one  of 
these  groups.  The  proper  place  is  in  that  group  which  contains 
the  cost  of  collecting  the  proceeds  of  the  sales. 

The  Credit  Department. — One  concern  may  decide  to  take 
its  chances  on  the  acumen  of  its  salesmen  and  so  maintain  no 
credit  department.  The  proportion  of  bad  accounts  may  be 
fairly  large,  but  not  large  enough  to  warrant  the  expense  of 
maintaining  a  competent  credit  force.    Another  concern  in  the 


314  AUDITING— GENERAL  PRINCIPLES 

same  line  of  business  may  have  a  well-equipped  credit  department 
and  its  losses  from  bad  accounts  may  be  very  small;  but  the  cost 
of  maintaining  its  credit  department  must  be  grouped  with  its 
bad  debts  losses  if  an  intelligent  comparison  with  the  other 
concern  is  desired.  For  these  and  other  reasons  the  provision 
for  bad  accounts  should  not  be  deducted  directly  from  the  gross 
earnings. 

The  Reserve. — The  reserve  for  bad  debts,  however,  should 
be  deducted  from  the  accounts  receivable  on  the  balance  sheet. 
It  is  not  a  liability  and  should  not  be  placed  among  liabilities  or 
on  the  liability  side  of  the  balance  sheet.  The  use  of  the  word 
*' reserve"  to  designate  the  amount  charged  as  an  expense  to 
cover  losses  arising  from  bad  accounts  is  confusing  to  many 
persons.  It  may  in  some  cases,  therefore,  be  better  to  use  some 
such  expression  as,  '' provision  for  doubtful  accounts,"  in  place 
of  the  more  formal  expression,  '' reserve  for  bad  debts." 

Taxation.— Bad  accounts  should  be  written  off  in  any  event; 
but  the  point  is  of  particular  importance  in  determining  tax 
liability.  Up  to  this  time  the  federal  government  has  refused  to 
permit  the  deduction  of  tax  reserves,  allowing  only  the  amounts 
actually  charged  off  on  the  books. 

Income  from  Work  in  Progress 

Earnings  which  are  represented  by  completed  transactions 
with  trade  debtors  must  be  clearly  distinguished  from  those 
earnings  which  are  represented  by  transactions  only  partially 
completed,  the  results  of  which  are  in  doubt.  Except  in  unusual 
cases,  no  profit  should  be  taken  unless  a  cause  of  action  has  arisen 
which  can  be  enforced  against  the  debtor.  In  other  words,  if 
work  in  progress  cannot  be  earmarked  as  being  for  a  definite 
customer,  or  if  it  has  not  proceeded  far  enough  to  form  the  basis 
of  an  action,  it  must  be  taken  into  the  inventory  and  valued  as  an 
inventory  item  and  not  as  an  account  receivable.  Ordinarily 
no  profit  or  loss  thereon  should  appear  in  the  income  account 


THE  INCOME  ACCOUNT— REVENUES  315 

except  when  there  is  a  definite  change  in  values  at  the  date  of  the 
balance  sheet  and  accuracy  demands  a  revision.  If  a  revision  is 
justified  the  result  thereof  must  appear  as  a  separate  item;  it 
must  not  be  merged  with  realized  income. '  But  if  work  is  under- 
taken ''on  order"  and  is  proceeding  satisfactorily,  and  if  it  is 
apparent  that  the  estimated  profit  thereon  will  be  realized,  more 
or  less,  then  it  is  perm^issible  to  take  credit  for  the  proportion  of 
profit  earned  to  the  date  of  the  income  account. 

Anticipating  Profits. — Ordinarily,  on  the  theory  that 
profits  must  not  be  anticipated,  this  principle  is  not  considered 
a  conservative  one.  In  trading  concerns  orders  are  frequently 
taken  far  in  advance,  and  goods  in  an  inventory  may  have  been 
sold  and  are  simply  awaiting  dehvery.  Accounting  authorities 
have  in  the  past  agreed  that  the  profit  on  such  sales  should  be 
deferred  to  the  period  in  which  delivery  is  made.  It  may  be 
pertinent  to  inquire  why  accounting  authorities  agree  that  a  profit 
can  be  taken  on  contracts  only  partially  completed  and  with 
many  contingencies  to  face,  any  one  of  which  may  delay  or 
prevent  the  fulfilment  of  the  contract  according  to  its  terms  and 
oppose  anticipating  the  profit  on  manufactured  goods  sold  and 
not  delivered.  Perhaps  the  best  and  frankest  answer  to  this 
argument  is  that  expediency  governs  one  case,  while  the  other 
practice  of  deferring  profits  almost  but  not  quite  realized  is  due  to 
conservative  commercial  practice. 

Under  ordinary  conditions  the  author  does  not  believe  that 
profits  on  undelivered  sales  should  be  anticipated.  Most  con- 
cerns which  sell  ahead  have  a  fairly  constant  and  uniform  business 
so  that  no  statistical  problem  arises  when  sales  expenses  are 
charged  to  one  period  while  the  following  period  reaps  the  benefit 
thereof.  But  a  shipbuilder  may  have  a  dozen  jobs  under  way  at 
the  end  of  one  fiscal  period,  while  he  may  have  six  or  eighteen 
jobs  under  way  at  the  end  of  the  next  period.  If  he  takes  up  the 
profit  on  completed  jobs  only,  his  books  may  show  a  state  of 


See  rules  for  inventory  valuations,  page  144. 


3l6  AUDITING— GENERAL  PRINCIPLES 

affairs  vastly  different  from  the  facts.  His  most  prosperous 
year  may  easily  show  up  as  the  worst.  The  same  is  true  of 
contractors  in  the  building  and  other  trades. 

It  may  be  urged  that  the  taking  of  a  profit  on  uncompleted 
work  is  an  extreme  example  of  the  practice  of  anticipating  earn- 
ings, a  practice  which  is  condemned  throughout  this  book.  This 
is  admitted.  It  should  be  borne  in  mind,  however,  that  when 
there  are  inventories  and  similar  assets  exist,  the  closing  of  the 
books  is  necessarily  based  on  estimates.  Many  serious  mistakes 
have  been  made  in  fixing  valuations  on  real  estate  and  stock-in- 
trade. 

Use  of  Estimates. — ^The  necessity  of  closing  at  a  fixed  date 
each  year  may  require  the  use  of  careful  estimates.  A  contractor 
who  over  a  period  of  years  carefully  estimates  the  value  of  work  in 
progress  and  who  conservatively  estimates  his  profits  thereon, 
arrives  at  figures  quite  as  trustworthy  as  are  secured  in  a  business 
whose  units  of  production  are  smaller  and  which  does  not  antici- 
pate profits.  Experience  in  dealing  with  contractors^  accounts 
soon  enables  the  auditor  to  verify,  at  least  approximately,  the 
accuracy  of  the  figures  submitted  for  work  in  progress. 

Fixed  Percentage  Basis. — Recently,  the  practice  of  having 
work  done  at  a  maximum  profit  or  upon  a  fixed  percentage  has 
been  extended  to  much  work  which  formerly  was  undertaken  for  a 
round  sum.  In  such  a  case  the  profit  is  determined  by  the 
amount  of  the  work  completed  and  may  be  taken  into  account  in 
the  same  manner  as  with  professional  earnings. 

Circumstances  Determine  Policy. — If  the  units  of  pro- 
duction are  small  and  if  the  time  of  completion  is  comparatively 
short,  and  when  there  are  no  substantial  fluctuations  in  prices, 
there  is  no  sanction  for  including  any  profit  whatever  in  the 
inventory  prices  of  unfinished  goods.  Under  a  very  accurate  and 
carefully  kept  cost  system  it  may  be  possible  to  arrive  at  the  cost 
price  of  work  in  progress.    The  auditor  should  ascertain  that  the 


THE  INCOME  ACCOUNT— REVENUES  317 

principles  upon  which  the  costs  have  been  calculated  are  correct 
and  should  also  satisfy  himself  that  the  quantities  have  been 
checked  and  certified  to  by  responsible  parties. 

Departmental  Profits 

It  is  held  by  some  accounting  authorities  that  when  the 
product  of  one  department  of  a  business  is  completed  and  is 
turned  over  to  another  department,  the  originating  department 
may  take  credit  for  its  production  at  the  market  price,  and  if  the 
market  price  is  in  excess  of  its  cost,  a  profit  is  earned  and  may  be 
taken  into  account  immediately. 

Stages  of  Manufacture. — It  is  pointed  out  that  in  some 
concerns  there  may  be,  say,  four  distinct  stages  in  the  manu- 
facturing process  between  raw  product  and  finished  goods. 
Other  and  competing  concerns  have  but  one,  two,  or  three  of 
these  stages,  so  that  what  is  an  intermediate  stage  for  one  is 
raw  material  for  another. 

For  instance,  a  steel  manufacturer  mines  his  own  ore  and 
manufactures  his  own  pig  iron.  A  competitor  purchases  all  of 
his  pig  iron.  The  former's  iron  costs  $io  per  ton;  the  latter,  hav- 
ing to  buy  on  the  market,  is  not  able  to  secure  iron  under  $12  per 
ton.  The  iron  is  used  to  manufacture  identical  products.  At 
what  price  should  the  former  concern  charge  the  department  to 
which  the  iron  is  delivered?  If  at  $10  per  ton,  the  manager  is 
credited  with  having  a  lower  cost  of  production  than  his  competi- 
tor, although  the  latter  may,  in  fact,  be  niore  efficient. 

Book  Profit. — So  far  the  argument  is  a  strong  one,  and  the 
point  is  conceded,  provided  the  interdepartmental  profits  are 
suspended  until  the  product  is  finally  disposed  of.  But  if  they 
are  not  thus  suspended,  a  concern  manufacturing  its  goods  from 
the  first  stage  to  the  last  may  find  itself  in  possession  of  a  large 
inventory  of  manufactured  goods  and  a  large  apparent  book 
profit  and  yet  be  wholly  unable  to  convert  this  book  profit  into 
cash. 


3l8  AUDITING— GENERAL  PRINCIPLES 

In  order  to  reflect  actual  values  for  comparative  purposes  and 
in  order  to  determine  the  efficiency  of  different  departments,  it 
may  therefore  be  permissible  to  adjust  costs  to  market  prices, 
provided  that  in  all  cases  such  intermediate  profits  are  held  in 
reserve,  and  this  reserve  is  clearly  shown  on  the  balance  sheet, 
until  there  has  been  a  conversion  into  cash  or  its  equivalent. 

Conclusion. — A  complete  answer  to  the  demand  for  an 
earlier  disposition  of  these  profits  is:  The  purpose  of  organizing 
an  enterprise  which  includes  various  stages  of  manufacture  is  to 
produce  a  given  article  finished  for  market  at  the  lowest  possible 
price,  and  the  more  numerous  the  stages  covered,  the  lower  is  the 
cost.  This  is  not  the  case  when  credit  is  taken  for  a  series  of 
profits  throughout  the  process  of  manufacture,  since  this  obscures 
the  actual  cost  of  the  finished  article. 

Intercompany  Profits 

In  recent  years  there  has  been  a  tendency  to  concentrate 
production.  Consequently,  this  same  problem  arises  with  respect 
to  intercompany  profits.  In  the  case  of  intercompany  transac- 
tions the  principle  applied  to  interdepartmental  income  should 
be  observed. 

The  Correct  Procedure  Illustrated. — Some  large  in- 
dustrial enterprises  control  several  or  all  of  the  processes  of 
manufacture  of  one  or  more  products.  Frequently  the  various 
processes  are  performed  by  plants  which  are  entirely  distinct 
units  operating  under  their  own  individual  charters.  As  a 
consequence  frequent  sales  and  resales  are  made,  with  the  result 
that  profits  are  shown  on  intercompany  sales  and  quantities  of 
merchandise  appear  in  the  inventories  at  prices  greater  than 
actual  cost.  It  is  now  generally  recognized  as  good  accounting 
practice  to  eliminate  all  intercompany  profits  and  the  corre- 
sponding excessive  inventory  valuations  from  statements  which 
purport  to  show  the  true  financial  status  of  the  group  of  related 
companies.    The  United  States  Steel  Corporation,  for  example, 


THE  INCOME  ACCOUNT— REVENUES         319 

in  its  consolidated  balance  sheet,  lists  its  inventories  of  products 
on  hand  which  have  been  sold  and  transferred  from  one  subsidiary 
company  to  another,  at  net  value,  i.e.,  substantially  the  cost  of 
production  to  the  companies  which  furnish  the  products.^ 

The  foregoing  represents  sound,  conservative  accounting  and 
should  be  followed  by  every  corporation  which  desires  to  allow 
the  future  to  reap  the  benefit,  if  any,  of  future  transactions,  rather 
than  to  sell  goods  to  itself  at  a  profit. 

Income  from  Sales  for  Future  Delivery 

As  mentioned  under  "Income  from  Work  in  Progress,"^  it  is 
customary  in  many  lines  of  business  to  solicit  and  accept  orders 
for  future  delivery.  If  the  expenses  of  taking  the  orders  have 
been  incurred  and  if  the  goods  themselves  are  on  hand  ready  for 
delivery,  it  may  seem  ultra-conservative  to  advocate  waiting  for 
actual  shipments  before  taking  credit  for  the  profit  thereon. 
Nevertheless,  this  practice  is  generally  followed  by  successful 
concerns,  whereas  the  unsuccessful  business  man,  in  his  attempts 
to  bolster  up  a  tottering  business,  usually  anticipates  every  profit 
in  sight  and  forgets  the  accrued  expenses. 

Danger  of  Cancellations. — Theoretically,  if  goods  have 
been  sold  and  are  ready  for  shipment  and  if  the  terms  of  the  order 
permit  immediate  shipment,  it  may  be  assumed  that  a  cause  of 
action  has  so  nearly  arisen  that  no  great  harm  can  follow  if  the 
goods  are  entered  as  a  sale,  accounts  receivable  are  debited,  and 
the  income  account  increased  by  the  profit.  But  every  business 
man  knows  that  up  to  the  instant  of  shipment,  and  sometimes 
afterwards,  cancellations  are  received  and  accepted,  or  that  a  fire  or 
some  other  contingency  may  prevent  the  consummation  of  what 
appears  to  be  a  sure  thing.  Under  normal  conditions  the  con- 
servative business  man  does  not,  and  will  not,  anticipate  the 


"  See  Wm.  M.  Ly brand,  year  book  of  the  American  Association  of  Public 
Accountants  for  1908,  page  255;  also  the  annual  reports  of  the  United  States 
Steel  Corporation. 

3Page3i4. 


320  AUDITING— GENERAL  PRINCIPLES 

profits  on  goods  ordered  but  not  shipped;  the  conservative  auditor 
will  not  certify  to  accounts  which  are  prepared  on  any  such  basis. 
In  a  going  business  it  is  assumed  that  orders  are  in  hand  for 
future  delivery,  and  when  prices  are  reasonably  stable  the  profit 
on  such  orders  should  appear  in  the  period  during  which 
deliveries  are  made.  In  such  cases  inventories  are  valued  at 
original  cost,  which  is  the  same  as  replacement  cost;  therefore 
balance  sheets  are  not  affected.  When  replacement  costs  are 
greater  or  less  than  original  cost,  succeeding  periods,  as  well  as 
balance  sheets,  are  unduly  affected,  unless  adjustments  are  made 
as  at  the  date  of  the  balance  sheets.  "* 

Participations  and  Underwritings 

During  recent  years  bankers  have  extended  the  privilege  of  par- 
ticipating with  themselves  in  underwritings  and  purchases  to  a  con- 
siderable number  of  investors  and  others.  It  is  therefore  not  unus- 
ual to  see  some  reference  to  such  participation  in  books  of  account. 

Perhaps  a  majority  of  underwritings  yield  a  net  income  to 
participants,  but  many  wind  up  with  a  loss.  Interim  accounts 
are  reports  of  progress  only  and  may  be  founded  on  the  quotation 
of  a  supported  market,  so  that  it  is  most  unsafe  to  take  into 
account  any  income  at  all  until  it  is  realized  in  cash. 

This  rule  applies  with  equal  force  when  securities  of  a  new 
corporation  are  distributed  as  a  bonus.  There  may  be  a  market 
price  which  seemingly  insures  a  handsome  profit,  but  such 
quotations  may  be  nominal  only.  The  sale  of  a  part  of  the  parti- 
cipation at  a  profit  on  the  purchase  price  should  be  applied  against 
the  entire  purchase  in  order  to  write  down  its  book  cost.  This  is 
based  on  the  same  principle,  viz.,  that  the  market  may  be  a  ficti- 
tious one  and  therefore  is  not  to  be  depended  upon. 

Income  Arising  from  Sale  of  Capital  Assets 

It  may  be  that  a  profit  has  been  realized  from  the  sale  of 


a  portion  of  the  fixed  assets  of  a  concern.  JLegally -feiiis  profit  may 
L  fs, 


4  For  discussion  of  this  subject,  see  page  i6o. 


^ 


THE  INCOME  ACCOUNT— REVENUES  321 

be  carried  to  surplus  and  distributed  as  a  dividend,  but  such  a 
course  is  apt  to  create  a  false  impression  on  stockholders.  It  is 
much  better  to  carry  such  an  item  to  an  account  such  as  capital 
surplus,  whose  caption  indicates  the  character  of  the  entries  there- 
in, and  which  may  be  carried  on  a  balance  sheet  as  a  separate 
section  of  the  surplus  account.  Under  such  circumstances  it  does 
not'  appear  to  be  applicable  to  dividend  distributions  but  can  be 
held  as  a  contingent  reserve  against  possible  losses  on  other  capi- 
tal adjustments. 

Income  from  Royalties 

When  royalties  are  received  as  a  result  of  the  disposal  of  pat- 
ent rights,  lease  of  ore  lands,  etc.,  the  auditor  should  examine  the 
contract  or  agreement  to  determine  the  basis  of  the  royalty 
charges.  In  many  cases  royalties  are  based  upon  sliding  scales 
or  upon  output  or  some  other  contingency  which  should  be 
verified. 

Appreciation  in  Value  of  Assets 

It  has  been  suggested  elsewhere  in  this  book  that  appraisal 
companies  are  apt  to  certify  to  valuations  in  excess  of  book 
figures.  It  must  be  said  in  favor  of  these  companies  that  they 
seem  to  carry  on  their  appraisals  in  a  careful  and  conscientious 
manner  and  it  may  be  that  the  doubling  in  costs  of  materials  and 
labor  during  the  last  ten  years  justifies  their  apparent  over- 
valuations. 

Effect  on  Costs. — Many  business  men  who  secure  an  ap- 
praisal which  sets  forth  that  their  buildings  and  machinery  are, 
on  the  basis  of  a  replaceable  valuation  less  depreciation,  worth 
more  than  they  cost  originally,  wish  to  set  up  on  their  books  and 
statements  this  diagnosis,  but  do  not  like  to  be  told  that  they  are 
making  trouble  for  themselves.  They  have  a  larger  valuation 
to  wipe  out  by  means  of  depreciation  reserves,  and  thus,  in  a  sense, 
they  are  increasing  their  cost  of  production.    After  a  credit  to 


322  AUDITING— GENERAL  PRINCIPLES 

current  or  earned  surplus  account  is  once  made,  it  is  most  unlikely 
that  any  part  thereof  will  be  used  except  for  dividends. 

Where  the  book  value  is  increased,  with  a  corresponding  credit 
to  a  special  reserve  account,  and  the  periodical  provision  for 
depreciation  is  increased  in  proportion,  the  amount  of  the  increase 
might  be  credited  to  surplus  on  the  theory  that  this  was  an  addi- 
tional earning  due  to  an  increase  in  the  asset  value.  In  reality, 
there  is  no  change  in  the  final  result  because  the  special  earning 
is  offset  by  the  increased  cost.  All  that  is  gained  is  an  increased 
cost  figure  based  to  a  certain  extent  on  the  increased  valuation 
due  to  the  appraisal. 

If  it  is  contemplated  that  the  current  income  account  shall  be 
charged  with  sufficient  depletion  or  depreciation  to  replace  the 
appreciated  value  of  the  asset,  the  periodical  charge  must  be  on 
the  basis  of  the  written-up  value;  this  is  proper  procedure  under 
federal  income  tax  practice.  Under  ordinary  accounting  pro- 
cedure, income  is  debited  only  with  such  amounts  as  will  renew 
the  original  cost  of  the  asset;  surplus  arising  from  revaluation  of 
assets  is  debited  with  the  difference  between  depletion  or  depreci- 
ation based  on  appreciated  value  and  cost. 

Valuations  as  of  March  i,  19 13. — It  is  entirely  proper  to 
set  up  actual  values  at  such  dates  as  March  i,  19 13,  for  tax  pur- 
poses; but  such  revaluations  should  be  so  clearly  stated  in  books 
of  account  and  balance  sheets  that  no  one  will  be  deceived. 

Paying  Dividends. — The  law  on  the  subject  of  profits  is  not 
well  settled,  but  it  is  quite  likely  that  no  legal  obstacle  can 
prevent  a  corporation  from  revaluing  part  of  its  assets  and 
applying  the  excess  so  raised  to  surplus  available  for  dividends. 
With  the  law  in  such  an  unsatisfactory  condition  it  is  the  pro- 
fessional auditor's  duty  to  educate  the  business  public  to  the 
principle  that  it  is  not  only  foolhardy  but  unscientific  to  write  up 
the  value  of  an  asset  which  is  not  for  sale  and  which  therefore 
cannot  be  represented  by  cash  or  its  equivalent.  Funds  for 
dividends  should  be  realized  from  earnings.    The  working  capital 


THE  INCOME  ACCOUNT— REVENUES  323 

of  a  company  is  permanently  depleted  if  a  cash  dividend  is 
declared  out  of  surplus  created  by  writing  up  assets. 

The  foregoing  applies  to  cases  where  assets  are  so  exhibited 
that  those  who  rely  on  published  statements  are  deceived,  and 
to  cases  where  earned  or  free  surplus  accounts  are  increased  with 
the  possibility  that  improper  or  improvident  dividends  will  be 
paid.  There  are  cases  where  appreciation  is  permanent  and 
obvious  and  where  failure  to  disclose  it  will  deceive.  It  may  be 
that  mining  properties  or  other  assets  have  so  greatly  increased 
in  value  that  mortgage  bonds  in  amounts  greatly  exceeding  book 
values  have  been  sold.  It  would  obscure  the  true  situation  if  the 
assets  were  not  written  up  to  actual  value.  Of  course  the  excess 
above  book  value  should  be  credited  to  ^'surplus  arising  from 
revaluation"  and  not  to  earned  surplus. 

Cost  as  Basis. — Capital  assets  should  be  carried  at  cost  unless 
and  until  some  change  occurs  v/hich  justifies  a  revaluation.  In  a 
going  business,  the  ownership  or  control  of  which  does  not  change, 
revaluations  may  be  made  at  any  time  provided  the  changes 
between  original  costs  and  revaluations  are  clearly  shown. 


CHAPTER  XVII 

THE  INCOME  ACCOUNT— EXPENSES  AND  LOSSES 

The  several  accounts  which  show  the  details  of  the  charges 
against  or  deductions  from  the  earnings  of  an  enterprise  are  fully- 
described  in  Chapter  XXV,  ''The  Detailed  Audit — Purchases 
and  Expenses."  There  are,  however,  certain  accounts  which  do 
not  arise  out  of  cash  transactions  and  others  which  need  addi- 
tional explanation.    These  accounts  will  now  have  our  attention. 

Reserves 

We  have  discussed  on  other  pages  the  following  reserve 
accounts : 

Doubtful  accounts,  page  90. 
Accrued  expenses,  page  270. 
Depreciation,  exhaustion,  etc.,  185. 
Obsolescence,  page  186. 
Contingencies,  page  247. 
Sinking  fund  accounts,  page  201. 

The  question  now  arises  how  and  when  these  charges  should 
appear  in  a  current  income  account.  The  fact  is  that  in  some 
cases  they  do  not  appear  in  the  current  income  account  at  all. 

Failure  to  Deduct  Expenses.^ — ^A  fair  proportion  of  the 
business  enterprises  of  this  country  which  consult  professional 
accountants  heed  the  advice  given  and  include  among  their 
expenses,  or  deductions  from  income,  all  of  the  costs  of  doing 
business.  The  words  "net  income"  are  not  used  by  them  except 
after  full  allowance  is  made  for  keeping  the  capital  intact.  Most 
of  the  remaining  concerns  and  those  who  consult  but  do  not  heed 
the  professional  auditor,  however,  include  among  their  income 
every  dollar  of  possible  income;  but  from  such  income  is  deducted 

324 


INCOME  ACCOUNT— EXPENSES  AND  LOSSES  325 

only  such  costs  and  expenses  as  are  apparent  and  easily  ascer- 
tained, the  balance  being  wrongly  designated  as  ^'net  income." 
This  balance  is  carried  to  surplus  and  is  thereafter  referred  to  as 
the  net  income  earned  during  the  period  stated.  Subsequently 
(but  only  if  the  period  has  been  a  prosperous  one)  various  deduc- 
tions are  made  from  surplus,  covering  depreciation,  adjustment  of 
inventories,  writing  off  of  accounts  receivable,  etc. 

Such  practice  seems  hopeless  to  the  auditor  who  is  familiar 
with  actual  conditions,  who  knows  that  about  99  per  cent  of  such 
deductions  were  direct  charges  against  income  and  that  most  of 
the  items  should  be  included  in  the  current  income  statements. 
But  business  men  will  fool  themselves,  and  corporation  officers 
and  directors  will  fool  their  stockholders  and  attempt  to  fool  the 
pubHc.  However,  a  slight  but  perceptible  progress  is  being  made, 
and  it  is  inevitable  that  some  day  the  words  *'net  income"  will 
have  the  same  meaning  as  the  word  '' sterling"  on  silver.  Laws 
and  custom  will  make  the  issuing  of  false  statements  such  as  are 
now  spread  broadcast  a  punishable  offense. 

Financial  Writers  Responsible. — In  this  respect  it  is 
regrettable  that  many  financial  writers  of  ability  who  should,  and 
perhaps  do,  know  better,  are  responsible  for  much  of  the  present 
unsatisfactory  state  of  affairs,  ijust  as  surely  as  a  corporation 
does  issue  a  carefully  prepared  balance  sheet  and  an  income  state- 
ment, probably  certified  to  by  reputable  auditors,  in  which  proper 
deductions  are  made  to  cover  the  items  heretofore  referred  to, 
just  so  surely  one  or  more  of  these  writers  wrongly  analyzes  its 
contents  for  the  edification  of  the  investing  public.  They  ignore 
the  deductions  for  depreciation,  etc.,  and  solemnly  state  that 
during  the  period  the  corporation  ''earned"  a  given  per  cent  on 
the  capital — carrying  out  the  rate  to  several  decimal  places. 
They  may  mention  incidentally  that  from  the  income  there  are 
certain  deductions,  thus  emphasizing  their  own  opinion  that  the 
actual  profit  is  the  one  used  as  a  basis  for  calculating  the  rate 
earned,  and  that  the  deductions  are  purely  voluntary. 


326  AUDITING— GENERAL  PRINCIPLES 

Investigators. — When  legislative  investigations  are  in- 
stituted, these  figures  are  also  used.  The  fallacy  has  been  carried 
so  far  that  some  corporations  that  have  not  and  never  can  earn 
a  dividend  on  their  common  stocks  are  cited  as  having  realized 
large  earnings.  In  the  case  of  the  United  States  Steel  Corporation 
nearly  all  of  the  financial  writers,  and  certainly  all  of  the  states- 
men (?),  who  have  investigated  its  affairs,  state  its  net  earnings 
over  a  period  of  years  as  being  many  millions  of  dollars  greater 
than  the  corporation's  accounts  themselves  show. 

The  Trouble  Explained. — What  is  the  real  trouble? 
Surely  accurate  accounts  are  desired.  Is  it  because  the  tendency 
to  overstate  profits  and  understate  losses  is  so  general  among 
business  men  that  no  standard  exists? 

Perhaps  public  accountants  are  themselves  somewhat  to 
blame  for  present  conditions.  Have  they  always  been  keen  to 
make  from  gross  income  all  the  deductions  of  which  they  have  had 
any  knowledge,  before  designating  any  one  sum  as  ^'net  income  "? 

The  fact  is  that  because  some  of  the  reserves  for  depreciation, 
etc.,  are  more  or  less  difficult  to  ascertain,  it  has  been  a  fairly 
general  custom  to  omit  them  entirely,  or  else  to  qualify  the  ac- 
count by  stating  that  the  net  income  is  so  and  so  exclusive  of 
some  very  large  costs  and  expenses.  Is  it  not  peculiar  that  this 
action  on  the  part  of  the  auditor  exactly  fits  in  with  the  wishes  of 
the  client  who  knowingly  overstates  his  profits?  Candidly,  is  it 
not  possible  to  estimate  more  closely  an  allowance  for  deprecia- 
tion than  it  is  to  estimate  the  valuations  of  fixed  assets  or  current 
inventories  to  which  the  auditor  so  cheerfully  certifies? 

Depreciation 

The  question  of  depreciation  is  important  enough  to  require 
an  entire  chapter  for  its  discussion  (see  Chapter  XXVIII),  but  at 
this  point  it  is  in  order  to  consider  whether  or  not  depreciation 
should  be  included  among  the  cost  and  expense  items  in  the 
current  income  accciint. 


INCOME  ACCOUNT— EXPENSES  AND  LOSSES  327 

In  the  preceding  section  attention  was  called  to  the  general 
practice  of  omitting  this  and  other  items  from  ordinary  operating 
accounts.  Accountants  of  experience  defend  this  practice  on  the 
ground  that  when  depreciation  has  not  been  calculated  at  all,  or 
when  an  arbitrary  amount  has  been  set  aside,  the  task  of  deter- 
mining a  fair  allowance — one  that  can  be  included  among  operat- 
ing costs  without  detracting  from  the  value  of  the  entire  state- 
ment— is  too  onerous  to  perform,  with  the  result  that  costs  are 
compiled  without  any  allowance  for  depreciation.  It  is,  of  course, 
assumed  that  mention  is  made  of  the  omission  before  any  final 
figures  are  certified  to. 

Proper  Treatment  of  Depreciation. — It  will  always  be 
admitted  that  wear  and  tear,  and  perhaps  obsolescence,  are  going 
on  all  the  time.  If  not  admitted  in  so  many  words,  the  repairs 
and  maintenance  accounts  speak  for  themselves.  The  usual  and 
time-worn  argument  against  provision  for  deterioration  is  that 
constant  attention  is  given  to  the  up-keep  of  the  plant  and  that 
renewals  and  repairs  are  looked  after  as  soon  as,  or  before,  occa- 
sion demands. 

Disregarding  for  the  moment  the  fact  that  there  is  always  a 
considerable  amount  of  accrued  wear  and  tear  not  sufficiently 
apparent  to  necessitate  immediate  attention,  we  may  consider 
the  question  whether  the  renewals  and  repairs  which  are  impera- 
tive are  always  included  among  the  expenses  or  costs,  and  recur 
regularly  enough  to  be  charged  up  as  incurred  without  upsetting 
the  equilibrium  of  the  accounts,  or  whether  these  expenditures 
ordinarily  fluctuate  so  greatly  that  factory  managers  are  justified 
in  leaving  them  out  of  consideration  in  self-defense,  since  when 
included  their  costs  vary  to  such  an  extent  that  comparative 
records  are  ludicrous. 

Now  in  the  case  of  fuel  no  such  difficulty  arises.  Purchases 
and  consumption  run  along  regularly  and  no  one  thinks  of  omit- 
ting its  cost.  Wherein  lies  the  essential  difference  between  the 
cost  of  fuel  consumed  under  a  boiler  and  the  accruing  loss  on  the 


328  AUDITING— GENERAL  PRINCIPLES 

purchase  price  of  the  boiler  itself?  Both  are  consumed  in  the 
process  of  manufacturing.  The  cost  of  both  must  be  reimbursed 
from  the  proceeds  of  the  sale  of  the  product  manufactured,  or  the 
capital  of  the  concern  is  depleted.  Capital  depletion  is  exactly 
what  happens  in  thousands  of  cases.  The  cost  of  fuel  is  made  a 
part  of  the  cost  of  the  product,  but  for  some  mysterious  reason 
the  cost  of  the  boilers  is  provided  in  some  other  way.  At  least 
that  is  the  effect  of  the  accounting  system  followed. 

Operations  of  First  Year. — The  most  flagrant  fallacy  is 
advocated  in  connection  with  the  accounts  of  the  first  year's 
operations  of  a  new  plant.  The  management,  if  sane,  knows  that 
the  buildings  and  machinery  will  not  last  forever  and  that  into 
every  unit  of  production  there  has  entered  some  part  of  the  entire 
cost  of  the  plant.  It  would  be  ridiculous  to  charge  the  total 
cost  of  buildings  and  machinery  to  the  operations  of  the  first 
year,  but  is  it  not  equally  unsound  to  make  no  charge  whatever 
to  operations  merely  because  the  exact  amount  of  the  charge  is 
somewhat  difficult  to  ascertain^ 

Situation  Restated. — Accounting  difficulties  are  compara- 
tive only,  and  accurate  accounts  always  require  careful  and  in- 
telligent attention.  If  the  same  thought  were  given  to  calculating 
what  proportion  of  the  cost  of  a  boiler  enters  into  the  cost  of 
operation,  as  is  given  to  determining  the  basic  costs  of  other 
elements  which  enter  into  the  manufacturing  operations  of  a 
modern  plant,  the  amount  arrived  at  would  be  accurate  enough 
to  form  a  dependable  item  of  prime  cost. 

Professional  auditors  fail  in  their  duty  whenever  they  allow  to 
pass  an  opportunity  to  elucidate  the  foregoing  principle.  Thou- 
sands of  enterprises  have  gone  into  bankruptcy  solely  because  their 
accounts  never  exhibited  the  full  cost  of  their  product.  As  soon 
as  accounting  practice  and  procedure  and  commercial  common 
sense  are  developed  to  the  point  where  an  allowance  for  deprecia- 
tion is  made  just  as  much  a  part  of  prime  cost  as  labor  or  mate- 
rials, a  considerable  number  of  business  failures  will  be  averted. 


INCOME  ACCOUNT— EXPENSES  AND  LOSSES  329 

Obsolescence 

The  author  is  not  prepared  at  this  time  to  support  the  con- 
tention that  an  allowance  for  obsolescence  is  an  item  of  prime  cost, 
as  is  one  for  depreciation.  The  latter  is  certain  and  cannot  be 
avoided  any  more  than  taxes  or  death. 

We  are  never  certain  of  the  future  effect  of  obsolescence.  It 
is  true  that  most  of  our  modern  machinery  has  superseded  other 
machinery  which  was  not  worn  out,  and  that  a  plant  built  ten 
years  ago,  which  counted  on  a  twenty-year  life  for  its  equipment 
and  set  up  a  depreciation  reserve  on  that  basis,  has  not  been  able 
to  renew  that  machinery  out  of  the  reserve. 

Take  the  case  of  a  machine  costing  $1,000  in  1908,  having  an 
estimated  life  of  fifteen  years,  and  a  scrap  value  of  $100.  There 
is  $900  to  charge  to  operations  and  a  depreciation  reserve  based 
on  the  expected  life  would  be  conservative  accounting.  In  19 15 
it  is  found  that  the  machine  is  obsolete  and  a  new  one  costing 
$1,500  is  purchased,  but  the  new  one  has  twice  the  capacity  of  the 
old.  Here  to  a  large  extent  we  find  our  answer.  An  old  machine 
should  not  be  superseded  by  a  new  one  unless  the  latter  has 
greater  efficiency  or  capacity.  This  supplies  authority  for  capi- 
talizing part  of  the  cost  of  the  new  machine  unless  the  new 
machine  costs  no  more  than  the  one  superseded. 

It  is  obvious  that  obsolescence  cannot  be  foreseen,  and  there- 
fore any  attempt  to  reduce  the  contingency  to  a  definite  allow- 
ance to  form  part  of  current  operating  costs  defeats  its  own  pur- 
pose. In  view  of  the  rapid  strides  in  all  of  the  mechanical  sciences, 
obsolescence  is  likely  to  continue  to  be  a  serious  factor  in  the 
ultimate  cost  of  producing  manufactured  goods.  Therefore, 
whenever  possible,  a  reserve  should  be  created  to  meet  the 
possibility,  but  the  reserve  should  be  provided  for  out  of  income 
before  stating  the  surplus  applicable  to  dividends,  never  as  an 
item  of  prime  cost. 

The  foregoing  references  are  to  specific  reserves  for  obsoles- 
cence ;  it  is  not  intended  to  discourage  liberal  allowances  for  depre- 
ciation which  in  effect  include  what  may  be  termed  ordinary 


330  AUDITING— GENERAL  PRINCIPLES 

obsolescence.  It  is  almost  impossible  to  differentiate  between  or- 
dinary and  extraordinary  depreciation;  but  in  practice  there  is  a 
distinction.  When  a  depreciation  rate  of  loper  cent  on  machinery 
is  fixed,  it  is  usually  assumed  that  the  possible  effective  life  is  more 
than  ten  years,  although  as  a  general  average  the  effective  life  of 
machinery  is  not  more.  The  element  of  obsolescence  operates 
to  reduce  the  average  life.  This  may  be  termed  ''ordinary 
obsolescence."  There  is  no  objection  to  separating  the  lo  per 
cent  rate  into  the  parts  applicable  to  depreciation  and  to  obsoles- 
cence; but  good  accounting  practice  does  not  require  segregation. 
Allowances  for  extraordinary  obsolescence  are  in  the  nature  of 
contingency  reserves,  because  they  anticipate  the  unknown.  It 
is  not  proper  to  make  charges  against  income  for  reserves  unless 
the  ultimate  disposition  of  the  reserves  is  reasonably  certain. 

Accrued  Expenses,  etc. 

It  is  perhaps  superfluous  to  say  that  the  items  of  expenses  in 
an  income  account  embrace  those  which  have  accrued  during  the 
period,  whether  paid  for  or  not.  At  the  closing  date  all  accrued 
expenses,  rents,  taxes,  interest,  and  similar  items  should  be 
ascertained  and  entered  as  liabiHties  on  one  side  and  charged  to 
their  respective  expense  accounts  on  the  other. 

Since  many  of  these  expenses  are  more  or  less  unusual  in  their 
nature,  it  seems  that  some  are  unavoidably  omitted.  The  ques- 
tion then  arises  in  subsequent  audits,  whether  or  not  the  items 
applying  to  prior  periods  should  be  charged  to  surplus  or  be 
included  among  the  current  expenses  of  the  period  in  which  paid. 
There  are  two  reasons  in  favor  of  the  latter  practice  but  no  good 
reason  in  favor  of  the  former.  In  the  first  place,  when  charges  are 
made  against  an  old  book  surplus  it  simply  means  that  so  far  as 
published  accounts  go  they  are  never  in  evidence.  That  is,  the 
items  are  not  known  at  the  time  and  are  therefore  omitted  from  the 
accounts  in  the  period  to  which  they  belonged,  and,  being  elimi- 
nated from  the  period  in  which  paid,  they  practically  disappear. 

The    most    valuable    records    compiled    are    comparative 


INCOME  ACCOUNT— EXPENSES  AND  LOSSES  33 1 

schedules  of  earnings  and  expenses,  and  when  these  are  carried 
along  from  year  to  year  it  is  practically  impossible  to  adjust 
reports  which  are  perhaps  a  year  old  and  of  which  frequent  use 
has  been  made.  Therefore,  proper  accounting  practice  permits 
the  inclusion  of  such  items  in  the  current  income  account,  without 
calling  special  attention  to  the  matter,  unless  the  items  are  large 
enough  to  alter  materially  the  results,  in  which  case  the  items 
are  deducted  from  the  net  income  of  the  current  year  before  a 
transfer  to  surplus  is  made.  If  the  items  are  comparatively  small 
it  may  be  assumed  that  corresponding  items  are  omitted  from  the 
current  accounts.  These  will  have  to  be  taken  care  of  in  the 
subsequent  period. 

This  must  not  be  construed  as  an  excuse  for  closing  accounts 
before  every  known  liability  is  taken  into  consideration.  The 
auditor  who  does  not  satisfy  himself  that  all  known  liabilities 
and  those  which  should  be  known  are  included  in  a  balance  sheet, 
is  guilty  of  negligence  and  deserves  any  ill  consequence  which 
may  ensue. 

Trade  Discounts 

The  author,  in  common  with  most  practitioners,  has  always 
stated  that  trade  discounts  are  direct  deductions  from  invoices 
and  so  should  not  appear  in  the  books  of  account  of  the  seller  or 
of  the  purchaser. 

It  is  true,  however,  that  in  some  trades  considerable  emphasis 
is  placed  upon  the  variations  in  trade  discounts;  therefore  the 
student  of  accounts  should  be  given  an  opportunity  to  decide  for 
himself  whether  trade  discounts  have  any  place  in  books  of 
account.  This  point  assumes  importance  in  auditing,  because 
the  auditor  cannot  very  well  report  the  amount  of  trade  discounts 
given  or  received  unless  the  items  have  been  kept  separate 
throughout  the  accounting  period. 

Trade  versus  Cash  Discounts.— When  the  rate  of  discount 
for  prepayment  is  2  per  cent  flat  or  less,  it  is  proper  to  consider 


332  AUDITING— GENERAL  PRINCIPLES 

it  a  true  cash  discount.  When  the  rate  of  discount  is  more  than 
2  per  cent,  it  is  not  logical  to  look  upon  it  as  a  premium  for  pre- 
payment.^ Many  so-called  cash  discounts  are  7  per  cent  flat. 
When  such  a  rate  is  used  it  is  not  logical  to  deal  with  it  in  any 
other  way  than  as  a  deduction  from  sales.  The  concern  making 
such  sales  should  deduct  the  discounts  (in  an  aggregate  sum  if 
more  convenient)  from  the  outstanding  accounts  and  the  pur- 
chasers should  deduct  the  discounts  from  their  cost  prices  and 
from  their  inventories.  The  rule  is  a  somewhat  rough  and  ready 
one  but  it  is  accurate  enough.  It  is  not  inflexible  but  should  be 
followed  unless  a  better  general  rule  can  be  devised.  In  defining 
''cost"  and  "net  sales"  there  must  be  some  uniformity  even 
though  precise  formulae  are  not  always  possible. 

Cash  Discounts 

Where  it  is  customary  to  permit  trade  debtors  to  deduct  a 
discount  for  cash  within  a  limited  period,  these  deductions  are 
entered  in  a  special  column  of  the  cash  book.  The  discount 
allowed  up  to  the  date  of  the  closing  will,  of  course,  appear  in  the 
books,  preferably  in  a  separate  ledger  account.  The  auditor 
should  ascertain  whether  discounts  are  taken  by  some  customers 
in  spite  of  the  fact  that  their  payments  are  made  long  after  the 
discount  period  has  expired. 

The  aggregate  of  cash  discounts  should  be  entered  among  the 
expenses  of  the  business  and  not  as  a  direct  deduction  from  gross 
earnings.  The  theory  is  that  the  discount  allowed  is  a  premium 
given  to  secure  prompt  payment  as  well  as  for  the  use  of  the 
money  at  an  earlier  date  than  it  would  be  received  if  no  induce- 
ment were  offered.  If  these  allowances  are  strictly  cash  dis- 
counts, and  are  granted  only  if  the  debtor  pays  within  the  time 
specified,  they  are  clearly  an  expense  and  should  not  be  charged 


^  The  arbitrary  selection  by  the  author  of  2  per  cent  is  based  on  an  estimate 
of  its  approximate  accuracy;  in  any  event  it  affords  a  reasonable  basis  for  a 
general  rule  and  has  the  merit  of  being,  definite.  When  conditions  permit  the 
computation  of  some  other  rate  as  the  dividing  line,  the  more  accurate  rate 
should  be  used. 


INCOME  ACCOUNT— EXPENSES  AND  LOSSES  333 

against  sales  as  if  in  the  nature  of  an  abatement  of  the  purchase 
price  of  the  goods. 

DISPOSITION   OF   NET   INCOME 

When  an  auditor  has  determined  the  amount  which  he  is  willing 
to  certify  represents  '^net  income,"  the  difficult  part  of  his  task  is 
completed.  Probably  he  will  not  be  asked  whether  the  amount 
shown  should  be  paid  out  in  dividends  or  transferred  to  surplus,  and 
as  a  matter  of  principle  he  is  not  concerned.  However,  his  opinion 
may  be  asked,  and  if  so,  he  may  be  able  to  suggest  that  disposition 
of  the  net  income  which  is  for  the  best  interests  of  the  concern. 

Dividends 

Whether  to  declare  a  cash  or  a  stock  dividend  is  a  question 
which  may  very  properly  be  referred  to  the  auditor.  There 
should  be  no  transfer  of  net  income  to  general  surplus  account 
unless  the  entire  amount  is  applicable  to  dividends  when  and  if 
declared.  The  net  income  for  the  period  is  first  shown,  then  any 
transfers  which  have  been  authorized  by  the  board  of  directors 
are  deducted,  the  balance  being  carried  to  surplus.  This  practice 
of  carrying  the  balance  of  income  to  surplus  has  been  followed  for 
a  number  of  years  by  some  of  our  best-managed  corporations, 
and  has  the  sanction  of  law,  because  the  courts  have  repeatedly 
held  that  the  directors  of  a  corporation  need  not  declare  dividends 
unless  they  so  desire,  provided  they  can  show  that  the  funds 
which  would  be  required  for  dividend  disbursements  can  be  used 
to  better  advantage  in  the  business. 

When,  however,  the  directors  invest  the  surplus  in  securities 
the  control  of  which  is  not  a  necessary  incident  to  the  carrying 
on  of  the  business  for  which  the  corporation  was  organized,  they 
carry  this  practice  to  an  extreme  which  stockholders  never 
contemplate  when  they  purchase  stock. 

The  Law  in  England. — Table  A  of  the  EngHsh  Companies 
(Consolidated)  Act,  1908,  provides  in  section  99  as  follows: 


334  AUDITING— GENERAL  PRINCIPLES 

The  directors  may,  before  recommending  any  dividend,  set  aside 
out  of  the  profits  of  the  company  such  sums  as  they  think  proper  as  a 
reserve  or  reserves  which  shall,  at  the  discretion  of  the  directors,  be 
applicable  for  meeting  contingencies,  or  for  equalizing  dividends,  or  for 
any  other  purpose  to  which  the  profits  of  the  company  may  be  properly 
applied,  and,  pending  such  application,  may,  at  the  like  discretion,  either 
be  employed  in  the  business  of  the  company  or  be  invested  in  such  invest- 
ments (other  than  shares  of  the  company)  as  the  directors  may  from  time 
CO  time  think  fit. 

This  provision  is  not  necessarily  binding  on  all  English 
companies,  since  the  latter  may  incorporate  in  their  articles  of 
association  an  article  evincing  a  contrary  intent.  But  where 
articles  of  association  are  not  registered  or  where  there  is  no 
contrary  intent  on  such  articles  as  may  be  registered,  the  above 
provision  will  be  binding  on  the  directors  of  the  company. 

Position  to  Be  Taken  by  Auditor 

An  auditor  should  recommend  the  setting  aside  of  reserves 
for  contingencies  or  for  the  equalization  of  dividends  or  for 
other  reasonable  purposes,  so  long  as  the  financial  condition  of  a 
corporation  demands  conservative  financing;  but  when  it  finds 
itself  so  well  off  that  it  can  pay  all  of  its  debts  and  have  remaining 
cash  enough  to  purchase  investment  securities,  the  auditor  should 
allow  the  board  of  directors  to  take  all  responsibility  for  such 
action.  To  do  otherwise  savors  of  paternalism.  Stockholders 
forget  dividends  quickly,  and  it  is  therefore  not  thought  safe  to 
pay  out  big  dividends  in  good  years,  and  small  or  no  dividends  in 
poor  years.  But  some  stockholders  are  as  well  qualified  to  invest 
their  earnings  as  are  the  directors.  They  may  prefer  some 
variation  in  the  dividend  rate  to  an  attempt  to  build  up  a  big 
surplus,  thus  indefinitely  postponing  the  distribution  of  the 
earnings  of  a  particularly  prosperous  period. 


CHAPTER  XVIII 

CONSOLIDATED  BALANCE  SHEETS  AND 
INCOME  ACCOUNTS 

The  discussion  in  this  chapter  will  be  limited  to  matters  which 
arise  in  the  audit  of  accounts  which  should  be  consolidated  in  order 
to  exhibit  true  financial  conditions. 

The  audit  of  the  accounts  of  holding  companies  presents  very 
few  problems  which  are  not  found  in  the  audit  of  all  corporate 
accounts.  The  verification  of  the  assets  and  liabilities  and  of 
earnings  and  expenses  follows  the  same  line  as  has  been  fully 
discussed  elsewhere  in  this  book.  In  the  method  of  presentation 
and  publication  of  results,  however,  the  auditor  finds  questions 
of  great  importance.  Formerly  many  balance  sheets  and  income 
accounts  of  holding  companies  were  conspicuous  for  the  inform- 
ation which  they  did  not  disclose;  in  some  cases  there  was  de- 
liberate intent  to  deceive;  in  other  cases  it  was  assumed  that  the 
best  interests  of  the  stockholders  would  be  served  by  concealment 
of  the  facts.  Opportunities  for  diversion  of  assets  and  for  manip- 
ulation of  income  or  expenses  by  means  of  misleading  statements 
are  so  many  that  unusual  care  must  be  taken  to  disclose  all  of  the 
facts. 

An  auditor  is  no  more  justified  in  certifying  to  the  accounts 
of  a  holding  company  when  he  has  omitted  to  audit  the  accounts 
of  a  subsidiary,  than  he  is  in  certifying  to  the  accounts  of  another 
corporation  wherein  he  has  omitted  to  verify  the  accounts  of  its 
branches.    As  has  been  said:^ 

The  accounts  of  a  corporation  should  be  prepared  so  that  the  auditor 
can  certify  that  the  balance  sheet  represents  the  true  financial  position  of 


^  Geo.  R.  Webster,  "Consolidated  Accounts,"  Journal  of  Accountancy, 
Volume  28,  page  258. 

335 


33^  AUDITING— GENERAL  PRINCIPLES 

the  company,  and  that  the  profit  and  loss  account  is  a  fair  statement  of  the 
result  of  the  company's  operations.  It  has  long  been  recognized  by  ac- 
countants that  in  the  case  of  corporations  with  subsidiary  companies  these 
two  conditions  can  only  be  shown  by  the  preparation  of  consolidated  ac- 
counts. If  bankers  had  insisted  on  the  preparation  of  such  accounts  they 
would  probably  have  avoided  several  unpleasant  experiences.   .    .    . 

For  a  time  many  lawyers  were  opposed  to  the  presentation  of  consoli- 
dated accounts  by  companies  to  their  stockholders,  but  the  leading  law- 
yers engaged  in  corporation  practice  have  long  since  recognized  that  the 
technical  legal  situation  is  less  important  to  stockholders  and  the  public 
than  the  substantial  position  and  have  accordingly  accepted  the  principle 
of  consolidated  accounts.   .    .    . 

It  may  therefore  be  fairly  said  that  the  principle  of  consolidation  has 
attained  general  acceptance. 

The  existence  of  separate  legal  entities  seems  to  sustain  a 
belief  on  the  part  of  some  corporate  officers  that  a  different  degree 
of  accountability  exists  than  is  the  case  when  there  is  only  one 
legal  entity.  When  a  corporation  owns  and  operates  branches, 
no  one  thinks  of  publishing  the  head  office  accounts  and  omit- 
ting the  branch  accounts;  or  of  including  the  accounts  of  certain 
profitable  or  unprofitable  branches  and  omitting  others.  Such 
accounts  are  not  even  referred  to  as  being  consolidated;  it  is  taken 
for  granted  that  all  are  inseparable  parts  of  a  whole.  But 
formerly,  in  many  cases,  there  was  no  attempt  to  consolidate 
certain  of  the  accounts  and  in  some  cases  there  was  no  consoli- 
dation at  all.  When  there  is  control,  there  is  accountability; 
when  there  is  accountability,  there  should  be  complete  disclosure 
to  owners.  The  published  accounts  of  holding  companies  or  of 
affiliated  groups  should  be  stated  as  nearly  as  possible  in  the 
same  way  as  head  office  and  branch  accounts.  There  are  certain 
legal  and  accounting  difficulties  to  be  overcome  when  there  is 
not  complete  ownership;  but  on  the  whole  the  difficulties  are  not 
insuperable,  and  in  cases  where  the  most  complications  exist,  all 
such  problems  have  been  solved.  The  accounting  and 
constructive  requirements  of  consolidated  balance  sheets  and 
income  accounts  are  discussed  and  fully  explained  in  any  good 


CONSOLIDATED  BALANCE  SHEETS  337 

book  dealing  with  accounting  procedure.^  The  auditor  is 
concerned  chiefly  with  the  form  of  publication.  Elimination  of 
intercompany  transactions  automatically  permits  the  consoli- 
dation of  all  of  the  accounts.  In  no  other  way  can  the  facts  be 
presented. 

Definition  of  "  Subsidiary  " 

The  word  ^'subsidiary"  in  accounting  practice  means  a 
corporation  the  majority  stock  of  which  is  owned  by  another 
corporation.  The  term  does  not  include  corporations  which  are 
merely  controlled  through  substantial  minority  holdings  or  by 
means  of  operating  contracts. 

In  many  cases  the  accounts  of  partially  owned  subsidiaries 
are  not  consolidated  with  those  of  the  holding  company.  Owner- 
ship of  51  per  cent  of  the  stock  of  a  subsidiary  may  insure 
permanent  legal  and  operating  control;  but  the  relations  between 
the  holding  company  and  the  subsidiary  may  be  such  as  to  render 
it  unnecessary  or  objectionable  to  consolidate  the  accounts. 

The  Anaconda  Copper  Company  adopted  the  policy  in  1920 
of  consolidating  the  accounts  of  all  subsidiaries  which  were  75 
per  cent  or  more  owned.  So  far  as  any  uniformity  at  all  exists 
this  represents  present  practice.  Agreements  regarding  note 
issues  usually  define  subsidiary  companies  as  those  which  are  75 
per  cent  or  more  owned. 

BALANCE   SHEETS   OF   HOLDING   COMPANIES 

The  balance  sheet  of  a  holding  company  is  wholly  devoid  of 
the  information  an  investor  or  stockholder  seeks  unless  the  details 
of  the  assets  and  liabilities  of  the  subsidiary  corporations  are  set 
up  in  the  form  of  a  consolidated  balance  sheet. 


2  Anyone  interested  in  this  phase  of  the  subject  is  referred  to  the  paper  by 
WilHam  M.  Lybrand,  C.P.A.,  which  appears  in  the  Year  Book  of  the  American 
Association  of  PubHc  Accountants  for  1908,  page  255 ;  also  to  a  paper  by  Walter 
A.  Staub,  C.P.A.,in  Columbia  Income  Tax  Lectures,  192 1,  page  188,  entitled 
"Consolidated  Returns." 


VOL.  I — 22 


338  AUDITING— GENERAL  PRINCIPLES 

In  a  holding  company  balance  sheet  which  is  not  consolidated 
there  appears  on  one  side  a  huge  sum  opposite  the  caption, 
"securities  of  subsidiary  companies."  Then  there  will  probably 
be  another  item  representing  advances  (usually  also  large)  to 
subsidiaries;  there  may  be  a  little  cash,  but  other  assets  are  scarce. 
The  chief  criticism  leveled  against  such  a  balance  sheet  is  that  the 
absence  of  data  relative  to  the  quick  assets  and  liabilities  of  the 
subsidiaries  makes  it  impossible  to  form  an  opinion  as  to  whether 
the  concern  as  a  whole  is  properly  financed  or  whether  there  is 
absolute  need  of  additional  working  capital  to  prevent 
bankruptcy. 

The  balance  sheets  of  some  holding  companies  show  among 
the  assets  the  net  assets  of  the  subsidiaries.  That  is,  from  the 
accounts  receivable  and  inventories  are  deducted  the  accounts 
payable,  the  resulting  balance  being  shown  as  an  asset.  This  is 
obviously  wrong.  The  trade  debts  may  be  out  of  proportion  to 
the  assets  and  may  be  overdue  and  pressing. 

Strong  pressure  is  sometimes  brought  to  bear  on  an  auditor 
to  induce  him  to  prepare  the  balance  sheet  of  a  holding  company 
so  that  it  will  indicate  a  stronger  financial  position  than  actually 
exists.  The  best  answer  to  such  a  request  is  a  positive  declaration 
on  the  part  of  the  auditor  that  proper  accounting  procedure 
requires  a  certain  form  of  balance  sheet  and  that  there  will  be  no 
deviation  therefrom. 

The  elimination  of  intercompany  accounts  practically  clears 
the  balance  sheet  of  all  items  which  do  not  appear  in  the  ordinary 
balance  sheet  except  when  there  are  minority  interests.  In  the 
case  of  funded  debt,  the  consolidated  balance  sheet  shows  the 
funded  debt  of  the  holding  company  and  of  the  subsidiaries  in 
the  hands  of  the  public  set  forth  in  the  usual  way.  Likewise  the 
capital  stocks  of  the  holding  company  and  the  subsidiaries  in  the 
hands  of  the  public  are  separately  stated.  In  stating  the  surplus 
accounts  the  parts  applicable  to  the  holding  company  and  to 
the  subsidiaries  are  shown.  A  further  separation  is  usually 
required  to  show  surplus  at  date  of  acquisition  (which  is  capital 


CONSOLIDATED  BALANCE  SHEETS  339 

surplus  so  far  as  the  holding  company  is  concerned)  and  surplus 
earned  after  date  of  acquisition.  When  there  are  preferred  stock 
issues,  the  minority  interests  in  the  surplus  are  computed  on  the 
basis  of  preferred  stock  at  par,  unless  the  preferred  stocks  are 
entitled  to  a  share  in  the  profits;  in  such  cases  an  adjustment 
must  be  made. 

The  stock  in  the  hands  of  the  public  and  the  share  of  surplus 
applicable  thereto,  including  the  share  of  earned  surplus,  maybe 
shown  together.  As  stated,  the  share  of  surplus  accruing  to  the 
holding  company  is  treated  as  a  capital  item;  its  share  of  subse- 
quent surplus  is  merged  with  its  earned  surplus. 

Importance  of  Correct  Statement — Rediscounts 

The  importance  of  the  correct  statement  of  the  financial 
position  of  parent  and  subsidiary  companies  for  purposes  of 
determining  the  eligibility  of  commercial  paper  and  its 
desirability  for  rediscount,  is  set  forth  in  the  following  quotations 
from  a  letter  to  the  author  written  by  J.  H.  Case,  deputy  governor 
of  the  Federal  Reserve  Bank  of  New  York: 

We  have  always  felt  that  where  a  corporation  owns  all  or  enough  of  the 
capital  stock  of  another  corporation  so  that  the  latter  corporation  might  be 
considered  either  a  controlled,  a  subsidiary,  or  a  proprietary  concern,  the 
balance  sheet  submitted  should  be  the  consolidated  statement  of  the  parent 
and  the  subsidiary  corporation  in  order  that  we  might  have  full  informa- 
tion in  passing  upon  the  eligibility  as  well  as  desirability  of  the  paper  for 
rediscount  by  this  bank. 

In  addition  to  the  consolidated  balance  sheet  last  mentioned,  we  believe 
that  there  should  also  be  furnished  in  instances  of  this  kind,  separate,  in- 
dividual statements  giving  the  assets  and  liabilities  of  the  parent  company 
and  each  of  the  controlled,  subsidiary,  or  proprietary  concerns,  as  it  some- 
times happens  that  the  borrowing  is  done  not  by  the  parent  or  principal 
concern  but  by  the  subsidiary.  Moreover,  notes  of  a  purely  holding  com- 
pany as  a  general  rule  are  not  eligible,  although  the  paper  of  an  operating 
subsidiary  might  be,  provided  its  statement  showed  a  reasonable  excess  of 
quick  assets  over  current  liabilities. 

With  regard  to  affiliated  companies  as  distinguished  from  subsidiaries, 
which  may  not  be  owned  or  actually  controlled  by  another  corporation  but 


340  AUDITING— GENERAL  PRINCIPLES 

affiliated  through  common  ownership  or  otherwise,  we  do  not  feel  that  a 
consolidated  balance  sheet  discloses  the  required  information,  but  that 
each  of  the  affiliated  corporations  should  make  separate  financial  state- 
ments. 

Unless  complete,  detailed  statements  as  indicated  herein  were  avail- 
able, it  would  be  difficult  to  determine  whether  or  not  notes  of  this  char- 
acter would  be  eligible  for  rediscount  by  us,  under  the  regulations  of  the 
Federal  Reserve  Board. 

Consolidation  of  Affiliated  Interests. — One  of  the 
major  reasons  for  the  growing  practice  of  requiring  consolidated 
accounts  is  the  danger  of  suppression  of  unfavorable  affiliations. 
When  one  corporation  owns  all  or  nearly  all  of  the  stock  of  one 
or  more  other  corporations,  good  accounting  practice  requires 
consolidation;  when  an  individual  owns  all  or  nearly  all  of  the 
stock  of  more  than  one  corporation,  and  there  is  no  corporate 
ownership,  the  practice  is  not  settled.  The  auditor  should  be 
guided  by  the  relations  between  the  three  or  more  parties  in 
interest.  When  an  individual  owns  the  stocks  of  two  corporations 
and  the  inter-relations  are  such  that  separate  accounts  may 
mislead  those  who  are  entitled  to  information,  the  auditor  should 
insist  on  consolidating  all  of  the  jointly  owned  properties,  includ- 
ing the  accounts  of  the  individual.  In  the  foregoing  comments 
of  Mr.  Case,  the  thought  is  expressed  that  in  such  cases  consoli- 
dated accounts  alone  do  not  tell  the  whole  story,  and  separate 
statements  are  necessary.  It  is  obvious,  however,  that  separate 
statements  may  not  exhibit  the  status  of  the  affiliated  interests 
as  a  unit;  in  such  cases  consolidated  statements  supported  by 
separate  statements  should  be  prepared. 

Form  of  Balance  Sheet 

In  a  consolidated  balance  sheet  all  intercompany  accounts  are 
eliminated,  thus  exhibiting  the  debts  due  from  the  pubHc  and  to 
the  public.  Any  other  form  of  balance  sheet  which  includes 
as  assets  accounts  due  by  one  company  to  another,  and  as  habil- 
ities  accounts  due  from  one  company  to  another,  is  misleading 


CONSOLIDATED  BALANCE  SHEETS  341 

and  useless  for  the  purpose  of  disclosing  what  will  be  realized  from 
the  quick  assets  and  the  amounts  which  will  have  to  be  paid. 

Bonds  of  Subsidiary. — Some  question  may  arise  as  to  the 
treatment  of  bonds  of  a  subsidiary  not  guaranteed  by  the  holding 
company.  If  the  assets  of  the  subsidiary  are  sufficient  to  cover 
this  liability  the  point  is  an  academic  one,  but  instances  may  be 
found  in  which  the  bonds  of  a  subsidiary  are  not  fully  secured. 
The  consolidation  of  the  balance  sheet  of  one  with  the  other 
would  thrust  upon  the  holding  company  a  liability  not  directly 
assumed,  and  if  the  auditor  were  sure  that  no  contingent  liability 
existed  in  respect  thereof,  he  might  sanction  the  omission  of  both 
the  assets  and  liabilities  of  the  subsidiary.  As  mentioned  here- 
after, however,  it  will  usually  be  found  that  the  holding  company 
will  assume  such  a  liability  for  the  sake  of  continuing  the  business, 
in  which  case  the  full  amount  of  the  bonds  must  be  carried  as  a 
liability. 

Capital  Stock  of  Subsidiary. — It  is  obvious  that  the  capital 
stock  (all  or  partly  owned  by  the  holding  company)  of  a  subsidiary 
which  shows  a  deficit  is  of  no  value  unless  the  depreciation  in  the 
value  of  the  assets  is  abnormal,  and  unless  there  is  a  reasonable 
assurance  that  the  deficit  will  be  more  than  made  good  out  of 
future  earnings. 

Should  All  Items  of  Assets  and  Liabilities  Be  Segre- 
gated TO  Show  Minority  Interests  Therein? — Under  good 
accounting  practice  the  segregation  of  surplus  into  that  which 
inures  to  the  holding  company  and  minority  stockholders 
respectively  is  sufficient  recognition  of  the  minority  interest. 

Some  corporations  have  apportioned  to  minority  interests 
their  respective  shares  in  each  item  of  asset  and  liability  but  the 
practice  is  rare  and  has  little  to  commend  it. 

Agreements  and  deeds  of  trust  under  which  corporations 
borrow  money  sometimes  contain  provisions  which  require  the 
segregation  of  assets  in  the  same  ratio  as  the  majority  bears  to  the 


342  AUDITING— GENERAL  PRINCIPLES 

minority  interest.  These  agreements  are  made  with  the  specific 
purpose  in  view  of  conserving  the  net  current  assets  of  the  borrow- 
ing company,  and  precautions  are  taken  to  avoid  any  shifting  of 
assets  or  liabilities  to  the  detriment  of  the  lenders.  It  is,  of 
course,  necessary  to  comply  with  the  terms  of  the  agreements  and 
prepare  suitable  balance  sheets;  heretofore  it  has  been  assumed 
that  such  special  balance  sheets  are  not  of  interest  to  anyone 
except  the  trustee  named  in  the  agreement,  i.e.,  under  ordinary 
circumstances  the  balance  sheets  need  not  be  submitted  to  others 
than  those  who  are  specifically  entitled  to  them;  but  if  the  balance 
sheets  disclose  violations  of  the  agreements,  penalty  clauses 
operate  and  the  enforcement  thereof  may  produce  far-reaching 
results.  It  rests  with  the  trustee  named  in  the  trust  deed  to 
proceed  or  not.  This  contingency  raises  the  question  that  credi- 
tors other  than  those  who  are  parties  to  the  agreement  may  be 
entitled  to  know  that  the  other  creditors  have  it  within  their 
power  to  demand  immediate  payment  of  long-term  notes  or  ask 
for  a  receivership  or  take  other  action  which  might  prejudice  the 
equity  of  general  creditors.  Under  the  rule  that  all  material 
facts  regarding  financial  conditions  must  be  disclosed  on  the  face 
of  a  balance  sheet,  the  author  is  of  the  opinion  that  whenever 
agreements  of  the  nature  of  those  described  are  in  existence, 
reference  to  the  agreements  should  be  noted  on  the  face  of  the 
balance  sheet  so  that  any  creditor  who  desires  full  information 
may  secure  a  copy  of  the  agreement  and  inform  himself  regarding 
the  possibilities  of  default. 

When  Ownership  of  Minority  Interest  May  Be  In- 
cluded Among  Current  Assets  of  Holding  Company. — When 
a  holding  company  purchases  a  minority  interest  in  another  cor- 
poration, the  actual  investment  in  the  stock  is  the  only  item 
which  appears  in  the  books  of  the  holding  company  and  in  its  bal- 
ance sheet.  In  the  latter  the  item  appears  among  marketable 
investments  or  is  stated  separately,  depending  upon  intention  and 
availability.     If  there  is  a  free  market  for  the  stock  and  the  in- 


CONSOLIDATED  BALANCE  SHEETS  343 

tention  is  to  hold  it  for  temporary  investment,  the  item  properly 
appears  as  a  current  asset. 

When  Minority  Holdings  Are  Not  Current  Assets. — 
If  there  is  a  free  market  for  the  stock,  but  if  at  time  of  acquisition 
and  subsequently  the  intention  is  to  hold  it  indefinitely  because 
of  business  relations  or  other  commitments,  it  would  not  be 
proper  to  include  the  stock  in  the  current  assets. 

When  Majority  Interests  Are  Acquired. — When  one 
company  acquires  a  majority  interest  in  the  stock  of  another 
corporation,  good  accounting  practice  requires  a  disclosure  of 
details  which  is  not  called  for  in  the  case  of  minority  holdings. 
There  is  no  necessary  relation  between  the  procedure  required 
under  tax  laws  which  involves  technical  and  arbitrary  definitions 
of  *' invested  capital,"^  and  accounting  procedure  which  is 
designed  to  record  and  exhibit  financial  facts  irrespective  of  their 
relation  to  tax  liability;  therefore  the  books  of  account  and 
published  statements  should  reflect  good  accounting  methods. 

Records  in  Books  of  Account 

When  a  majority  interest  in  the  stock  of  another  corporation 
is  acquired,  the  purchase  price  represents  the  cost  of  the  invest- 
ment the  same  as  when  a  minority  interest  is  acquired.  The 
value  may  fluctuate  subsequently;  but  it  is  not  good  accounting 
practice  to  reflect  mere  fluctuations.  In  the  course  of  time, 
revaluations  may  be  deemed  to  be  necessary  in  order  to  represent 
what  are  believed  to  be  permanent  changes  in  value — up  or  down. 
Some  corporations  do  not  change  the  book  valuations  of  invest- 
ments in  the  stocks  of  other  corporations;  on  the  whole  the 
undoubted  advantage  of  not  marking  up  values  to  include 
appreciation  and  marking  down  values  to  represent  depreciation 
is  frequently  offset  by  the  disadvantage  to  stockholders  who  are 
kept  in  ignorance  of  permanent  favorable  changes  in  assets.     In 


3  For  discussion  of  consolidated  returns  and  other  technical  requirements 
under  tax  laws,  see  Excess  Profits  Tax  Procedure,  1921,  pages  282  to  330. 


344  AUDITING— GENERAL  PRINCIPLES 

more  than  one  case  minority  stockholders  have  been  deceived  and 
have  sold  out  in  ignorance  of  the  facts.  In  other  cases  old 
stockholders  have  sold  out  and  new  stockholders  have  bought  in 
at  greatly  inflated  prices  due  to  unfounded  rumors  regarding 
values  alleged  to  have  been  omitted  from  balance  sheets.  It  is  a 
perplexing  question.  Conservative  accounting  methods  have 
saved  thousands  of  concerns  from  failure.  It  is  not  wise  to 
depart  from  conservative  methods;  but  if  such  methods  can  be 
retained  and  more  information  be  furnished  so  that  those  entitled 
to  the  facts  will  not  be  deceived,  a  forward  step  in  accounting 
methods  will  have  been  made. 

Cost  Is  Sole  Criterion  Until  Conditions  Change. — 
There  has  been  much  discussion  regarding  the  possibility  of 
property  having  an  actual  value  at  the  time  of  purchase  in  excess  of 
its  purchase  price.  In  computing  invested  capital,  taxpayers  are 
subject  to  many  arbitrary,  technical,  and  in  many  cases  inequi- 
table restrictions;  offsetting  these  the  revenue  laws  permit  in 
certain  cases  the  inclusion  of  original  investment,  even  though 
it  may  have  been  greatly  reduced  by  losses,  excess  values  are 
included  as  ''paid-in  surplus,"  and  many  adjustments  of  book 
values,  such  as  restoration  of  assets  charged  off,  are  permitted. 
In  short,  computations  for  invested  capital  purposes  under  tax 
law  bear  no  necessary  relation  to  good  accounting  practice. 

From  a  common-sense  point  of  view,  property  is  worth  what 
it  costs,  unless  the  usual  elements  of  bargain  and  sale  are  absent. 
When  there  are  willing  buyers  and  willing  sellers,  cost  and  value 
at  time  of  acquirement  are  synonymous.  The  buyer  may  claim 
to  have  reaped  the  benefit  of  acquiring  something  which  is  worth 
more  than  it  cost  but  upon  inquiry  the  seller  may  claim  that  he 
received  full  value.  The  only  test  is  for  the  buyer  to  resell  or 
offer  to  resell  at  once;  unless  this  is  done,  the  estimate  of  simultan- 
eous appreciation  is  not  supported  by  competent  evidence. 

Auction  sales  furnish  interesting  comparisons.  Land  and 
personal  property  are  sold  and  resold  soon  thereafter,  often  at 


CONSOLIDATED  BALANCE  SHEETS  345 

prices  higher  than  cost.  We  do  not  often  hear  of  those  who  sell, 
or  would  like  to  sell,  at  less  than  cost  a  few  minutes  after  their 
bids  have  been  accepted.  As  a  rule,  resales  at  large  advances 
usually  occur  after  it  is  known  that  the  auction  sale  as  a  whole  is  a 
success.  Buyers  who  wait  and  pay  more  than  if  they  had  parti- 
cipated in  the  original  bidding  are  in  effect  buying  in  a  different 
market;  they  have  waited  and  they  ascertain  (or  think  they  ascer- 
tain) that  conditions  have  improved.  They  hope  to  resell  to  some- 
one else,  who  in  turn  thinks  that  another  even  more  favorable 
change  has  occurred.  This  goes  on  for  a  long  or  short  period, 
depending  on  the  atmosphere  and  the  degree  of  frenzy  which 
has  been  reached. 

Generally  speaking,  the  feeling  that  property  is  worth  more 
than  it  costs  proceeds  from  an  instinctive  optimism  following  a 
purchase.  No  one  cares  to  acknowledge  a  mistake  before  it  is 
necessary.  The  feeling  after  a  sale  is  just  the  opposite.  The 
greatest  "bear  "  is  the  sold  out  "bull."  No  one  cares  to  acknowl- 
edge that  he  sold  too  soon  or  for  less  than  his  property  was  worth. 

To  repeat — when  a  willing  buyer  and  a  willing  seller  close  a 
transaction,  the  former  should  not  simultaneously  claim  and  set 
up  on  his  books  a  value  in  excess  of  cost,  and  credit  the  excess 
to  surplus. 

Procedure  When  Cost  of  Holdings  in  Subsidaries  Is 
More  or  Less  Than  the  Book  Value  of  the  Shares  Pur- 
chased.— The  principle  of  the  danger  of  immediate  revaluation 
applies  to  the  purchase  of  a  majority  interest  in  the  stock  of  a 
corporation.  Assume  the  book  value  of  assets  to  be  $250,000, 
liabilities  to  be  $50,000,  capital  stock  $100,000,  and  surplus 
$100,000.  A  corporation  purchases  from  the  owners  80  per  cent 
of  the  stock  for  $100,000.  In  the  books  of  the  holding  company 
the  stock  should  be  carried  at  cost  ($100,000),  although  80  per 
cent  of  the  net  worth  of  the  subsidiary  is  $160,000.  Without 
independent  evidence  the  book  value  of  the  net  worth  may  not 
appear  to  be  overstated.     But  there  is  independent  evidence; 


346  AUDITING— GENERAL  PRINCIPLES 

the  owners  who  have  full  knowledge  of  all  facts  willingly  sell  for 
$100,000.  Therefore,  an  appraisal  at  that  time  of  more  than 
$100,000  ignores  the  opinion  regarding  value  of  one  who  got  all  he 
could  for  it. 

In  the  foregoing  case  a  consolidated  balance  sheet  after  elimi- 
nating intercompany  items  would  show  net  tangible  assets  of 
$60,000  in  excess  of  credits  to  offset.  If  there  is  a  good-will 
account  it  can  be  reduced  $60,000;  if  there  is  no  good- will  account, 
the  proper  reflection  of  the  actual  purchase  price  would  seem  to  be 
to  reduce  the  book  value  of  the  subsidiary  company's  fixed  assets. 
This  is  arbitrary  and  rests  on  the  assumption  that  the  current 
assets  are  properly  valued  and  that  fixed  assets,  being  difficult  to 
realize  on,  were  in  fact  sold  at  less  than  book  value. 

It  cannot  be  said,  however,  that  good  accounting  practice 
requires  that  the  book  values  of  tangible  property  be  written 
down  when  holding  companies  pay  less  than  book  value  for  shares 
purchased.  There  is  ample  authority  for  crediting  capital  sur- 
plus in  the  consolidated  balance  sheets  with  the  excess  of  book 
value  above  cost,  except  when  the  good-will  is  carried  at  a 
sufficient  amount  to  absorb  the  excess. 

It  seems  unnecessary  to  many  accountants  to  reduce  the  book 
value  of  the  subsidiary's  assets  when  there  is  no  apparent  over- 
valuation. On  the  other  hand,  it  seems  improper  to  add  to  sur- 
plus account,  even  though  the  surplus  arising  from  consolidation 
is  segregated  from  earned  surplus. 

The  payment  of  more  than  book  value  means  that  book  values 
are  understated  and  should  be  adjusted,  or  (as  is  usually  the 
case)  there  has  been  a  payment  for  good- will;  in  such  cases  the 
consoHdated  balance  sheet  should  show  the  facts.  It  is  not 
proper  nor  necessary  to  deduct  the  excess  from  surplus. 

The  foregoing  does  not  prevent  subsequent  reflection  of 
appreciation  which  occurs  after  the  date  of  the  purchase,  and 
when  permanent  appreciation  is  obvious.  The  auditor  may  find 
it  necessary  to  insist  on  a  readjustment  in  cases  where  a  consoli- 
dated balance  sheet  fails  to  reflect  the  reasonable  value  of  assets 


CONSOLIDATED  INCOME  ACCOUNTS  347 

owned  by  a  subsidiary.  It  may  be  that  a  bargain  purchase  was 
made  and  that  neglect  to  adjust  book  values  would  offer  oppor- 
tunities for  manipulation.  Cases  are  known  where  the  knowledge 
of  valuable  assets  owned  by  subsidiaries  has  improperly  been 
withheld  from  niinority  stockholders.  It  may  be  that  a  memo- 
randum on  the  balance  sheet  is  better  than  a  readjustment  of  the 
accounts. 

Guarantees  of  Subsidiaries'  Obligations 

It  has  been  pointed  out  elsewhere  that  good  accounting 
practice  now  requires  full  disclosure  of  indorsements,  guarantees, 
and  substantial  commitments  running  beyond  the  date  of  the 
balance  sheet.  In  some  cases  holding  companies  guarantee  the 
payment  of  contracts  entered  into  by  subsidiaries,  such  as  those 
for  merchandise  to  be  delivered  at  future  dates.  The  important 
point  is  full  disclosure  of  material  facts.  It  makes  little  difference 
how  the  contingent  liability  is  reflected  so  long  as  it  appears. 
Usually  a  statement  or  footnote  on  the  consolidated  balance  sheet 
giving  all  relevant  facts  is  sufficient  notice  to  all  who  may  be 
interested. 

INCOME  ACCOUNT 

A  consolidated  income  account  should  supplement  the  consoli- 
dated balance  sheet. 

Gross  Income. — Certain  holding  companies  continue  to  show 
as  gross  earnings  only  such  dividends  as  have  been  received  during 
the  period  from  the  subsidiary  companies.  Such  practice  merits 
the  strongest  censure.  The  author  has  heard  it  contended  that, 
inasmuch  as  the  only  legal  method  which  a  corporation  has  of 
distributing  profits  is  by  means  of  dividends,  it  is  most  improper 
for  a  holding  company  to  take  credit  for  part  or  all  of  the  earnings 
of  a  subsidiary  company  which  had  not  been  so  distributed. 
This  sounds  well  in  theory,  but  in  practice  it  is  the  argument  of 
dishonest  men.    Almost  invariably  the  sole  reason  for  taking 


348  AUDITING— GENERAL  PRINCIPLES 

advantage  of  this  technicality  is  that  one  or  more  of  the  subsid- 
iaries have  incurred  a  net  loss  in  excess  of  the  aggregate  profits 
of  all  of  the  companies,  and  the  management  of  the  holding 
company,  wishing  to  conceal  such  loss,  seeks  by  subterfuge  to 
justify  the  action. 

An  auditor  cannot  be  too  positive  on  this  point.  Wherever  a 
holding  company  owns  and  controls  one  or  more  subsidiaries,  the 
profits  or  losses  of  the  subsidiaries  must  be  stated  for  the  same 
period  as  that  of  the  holding  company  and  consolidated.  Any 
other  method  may  lead  to  gross  abuse. 

Dividends  Paid  by  Subsidiaries  to  Holding  Company. — 
Holding  companies  frequently  purchase  the  stocks  of  subsidiaries 
and  pay  considerable  premiums  above  par.  In  nearly  all  such 
cases  the  subsidiaries  have  large  surplus  accounts.  The  payment 
of  dividends  out  of  such  surplus  is  not  income  to  the  holding  com- 
pany, because  the  dividends  merely  offset  in  whole  or  in  part  the 
premiums  paid  for  the  stock.  For  this  reason  alone,  surplus  at 
date  of  acquisition  and  subsequently  earned  surplus  should  be 
segregated.  All  dividends  out  of  "prior"  surplus,  when  received, 
should  be  credited  to  the  holding  company's  investment  account. 

False  Statements. — The  directors  of  a  holding  company,  the 
sole  income  of  which  was  the  dividends  of  subsidiaries,  could 
withhold  dividends  from  prosperous  companies  while  they  were 
accumulating  the  stock  of  the  holding  company,  and  would  be 
lavish  with  such  dividends  whenever  they  desired  to  sell  their 
holding  company  stock.  This  is  not  mere  supposition  on  the 
part  of  the  author.  Holding  company  income  accounts  are  made 
up  in  the  manner  indicated,  and  inexperienced  professional 
auditors  are  sometimes  induced  to  certify  to  their  accuracy,  being 
misled  by  the  apparent  legality  of  the  procedure. 

Since  experienced  and  reputable  auditors  invariably  decline 
to  permit  their  names  to  be  connected  with  a  form  of  statement 
which  is  dishonest  in  fact  if  not  in  theory,  this  caution  as  to  the 
income  account  of  holding  companies  should  be  taken  advantage 


CONSOLIDATED  INCOME  ACCOUNTS  349 

of  by  an  auditor  who  may  have  the  matter  presented  to  him  for 
the  first  time. 

Two  Illustrations. — Ernest  Reckitt,  C.P.A.,  relates  the 
following  incident: 

I  have  in  mind  a  case  where  I  was  called  in  to  make,  as  I  supposed,  an 
audit  of  the  books  not  only  of  the  "Holding  Company,"  but  also  of  the 
subsidiary  companies,  and  was  amazed  to  find  that  it  was  proposed  to 
have  me  audit  only  the  "Holding  Company's"  books.  Upon  explaining 
that  I  could  give  no  certificate  on  such  audit,  the  most  specious  arguments 
were  advanced  and  the  president  of  the  company  attempted  to  use  the  full 
force  of  his  strong  personality  to  persuade  me  to  defer  to  his  wishes,  which 
naturally  only  made  me  suspect  still  more  the  motives  which  actuated  him. 
Finally,  and  with  great  reluctance,  they  handed  me  the  books  of  the  sub- 
sidiary companies,  and  I  found  out  that  two  of  the  companies  had  made 
losses  aggregating  over  $200,000  no  part  of  which  losses  had  been  taken 
care  of  on  the  books  of  the  "Holding  Company,"  though  they  had  been 
careful  to  bring  on  to  the  books  of  the  "Holding  Company"  the  profits 
made  by  other  subsidiary  companies.  One  year  later,  the  "Holding  Com- 
pany" and  most  of  the  subsidiary  companies  were  in  bankruptcy,  as  they 
deserved  to  be. 

The  author  was  called  upon  several  years  ago  to  audit  the 
accounts  of  a  holding  company  in  a  large  southern  city,  and  of  all 
of  its  subsidiaries.  The  latter  included  enterprises  of  different 
kinds  but  since  the  holding  company  owned  practically  all  of  the 
stock  of  each  underlying  company,  it  was  necessary  to  consolidate 
the  operations  of  the  entire  group  in  order  to  show  its  exact  net 
earnings.  Unfortunately,  several  of  the  concerns  were  not 
profitable,  and  the  consolidated  income  account  was  not  a 
document  to  be  proud  of. 

One  of  the  subsidiaries,  however,  was  quite  prosperous,  and  its 
net  earnings  in  themselves  were  sufficient  to  pay  interest  and 
dividends  on  the  holding  company's  bonded  debt  and  capital 
stock,  but  the  losses  of  the  other  companies  seriously  depleted  the 
funds  of  the  holding  company  and  rendered  dividends  impossible. 

A  short  time  afterwards,   the  president  of  the  company 


350  AUDITING— GENERAL  PRINCIPLES 

appeared  in  New  York  with  a  large  block  of  the  holding 
company's  bonds  for  sale.  He  submitted  to  the  bankers,  not  the 
auditor's  report,  but  a  statement  showing  the  earnings  of  the 
profitable  subsidiary  and  ignoring  so  far  as  possible  the  existence 
of  the  other  companies,  and  the  bonds  sold  readily. 

Should  Entire  Losses  of  Subsidiaries  Be  Absorbed  by 
Holding  Company? — The  foregoing  discussion  has  been  based  on 
a  division  of  profits  and  losses  on  a  mathematical  computation. 

If  a  profit  is  shown,  the  amount  to  be  included  as  the  share  of 
the  holding  company  is  the  proportion  the  stock,  owned  by  the 
holding  company,  bears  to  the  total  capital  outstanding.  It  must 
be  assumed  that  the  minority  stockholders  will  eventually  receive 
through  dividends  their  share  of  the  profits. 

If  a  loss  is  shown,  and  if  losses  form  the  chronic  condition  of 
the  subsidiary,  it  may  as  well  be  recognized  that  the  holding 
company  must  assume  all  of  them.  This,  of  course,  applies  only 
to  those  cases  in  which  a  subsidiary  company  is  so  largely  owned 
by  the  holding  company  that  the  minority  interest  cannot  be 
depended  upon  to  advance  its  share  of  the  funds  necessary  to  take 
care  of  the  loss. 

The  holding  company  may  carry  these  advances  as  an  asset, 
but  the  auditor  should  place  such  a  value  upon  these  items  as  the 
facts  warrant,  and  it  is  reasonably  certain  that  the  final  result  will 
be  to  include  all  of  the  loss  in  the  consolidated  income  account, 
although  something  less  than  loo  per  cent  of  the  stock  of  the 
subsidiary  is  owned. 

Comparative  Statements 

When  the  accounts  of  several  subsidiaries,  operating  along 
substantially  the  same  lines,  are  examined,  one  very  important 
object  is  to  endeavor  so  to  state  the  accounts  that  the  results  are 
reduced  to  a  uniform  basis.  Many  adjustments  may  be  necessary 
to  take  care  of  local  conditions,  etc.,  but  no  form  of  presentation 
is  clearer  or  more  valuable. 


CONSOLIDATED  INCOME  ACCOUNTS  35I 

When  comparative  costs  are  feasible,  it  is  important  to 
ascertain  the  amount  of  the  plant  investment,  since  it  may  be 
that  the  costs  as  reported  do  not  include  depreciation  or  interest. 
The  latter  is  usually  omitted  from  costs  on  the  ground  that  it  is  a 
profit  on  capital  employed  and  therefore  cannot  be  an  element 
of  cost.  Admitting  this,  *' without  prejudice,"  it  may  neverthe- 
less serve  to  conceal  lack  of  ability  on  the  part  of  the  manager 
of  one  factory  as  compared  with  that  of  another.  One  may 
keep  twice  as  much  capital  tied  up  in  raw  materials  and  goods 
in  process  as  the  other,  and  if  units  of  costs  are  stated  in  fractions 
of  a  cent,  the  interest  on  the  excessive  capital  employed  may  be 
sufficient  to  prove  the  superiority  of  one  manager  over  another. 


CHAPTER   XIX 
CERTIFICATES   AND   REPORTS 

What  shall  it  benefit  an  auditor  if  he  perform  the  highest 
grade  of  professional  work  and  be  unable  to  present  his  results  in 
a  form  acceptable  to,  and  understandable,  by  his  client?  Yet 
this  happens  every  day,  chiefly  because  some  auditors  apparently 
prepare  reports  for  themselves  rather  than  for  those  they  are 
supposed  to  enlighten.  An  engineer  builds  a  bridge  for  others  to 
use.  It  is  useless  unless  it  is  safe  and  convenient.  The  man  who 
rides  across  it  does  not  care  how  many  difficult  problems  were 
encountered  in  building  it,  nor  how  they  were  solved;  he  is 
content  to  judge  the  engineer  by  results.  So  with  a  banker  or  a 
business  man.  He  employs  an  auditor  because  he  wants  results, 
and  he  wants  results  which  he  can  use  without  having  to  follow 
in  the  auditor's  footsteps  and  traverse  the  same  jungles  of  figures 
and  grapple  with  the  same  problems  through  which  the  results 
were  accomplished. 

As  pointed  out  in  Chapter  IV,  the  auditor  should  prepare  for 
the  termination  before  he  starts,  and  since  the  consummation 
of  an  audit  must  include  a  report  on  his  work,  this  fact  must 
be  kept  in  view  during  the  progress  of  the  work. 

If  feasible,  the  auditor  should  picture  himself  in  his  client's 
position  and  reason  out  what  he  would  want  if  the  other  man 
were  doing  the  work.  The  examination  may  be  started  under 
most  favorable  auspices,  and  it  may  be  executed  in  an  unexcelled 
manner;  but  if  it  is  not  reported  upon  properly,  the  first  two 
factors  will  go  for  naught. 

It  hardly  seems  necessary  to  state  that  reports  should  be 
typewritten  and  an  office  copy  preserved,  yet  auditors  are 
frequently  induced  to  submit  manuscripts  of  which  no  copy  is 
retained.     Subsequent  embarrassment  has  followed  this  unwise 

352 


CERTIFICATES  AND  REPORTS  353 

practice,  through  loss  of  the  original,  unauthorized  alterations 
therein,  etc.  It  is  better  to  keep  a  client  waiting  than  to  run  such  a 
risk.  Promises  to  return  reports  for  rewriting  may  not  be  kept, 
and  the  auditor  who  relies  on  these  and  similar  promises  ignores 
a  precaution  which  experience  has  demonstrated  to  be  valuable. 

Something  More  Than  Figures  Are  Wanted  in  a  Report 

A  prominent  banker  recently  said  to  the  author  that  most  of 
the  reports  submitted  to  him  lack  information  which  the  auditor 
is  peculiarly  able  to  furnish.  He  said  that  auditors  who  are 
retained  to  investigate  earnings,  expenses,  assets,  and  liabihties, 
frequently  going  back  over  a  long  series  of  years,  have  an 
unusually  good  opportunity,  for  instance,  to  size  up  the  personnel 
of  an  organization,  particularly  the  office  staff,  and  also  to  a 
certain  extent  the  other  departments. 

A  banker  is  obliged  to  vouch  for  an  enterprise  as  a  whole  when 
he  offers  its  securities  to  his  customers.  He  wants  the  assets  and 
liabilities  and  net  income  stated  in  form  suitable  for  publication, 
and  requires  that  a  certificate  be  attached  which  reads  well;  but 
he  also  wants  a  supplemental  report  for  his  own  use,  expressing 
the  auditor's  opinions  on  just  as  many  points  as  the  latter  can 
comment  on  intelligently.  He  does  not  want  trial  balances  and 
lists  of  debtors  and  creditors  and  memoranda  of  errors  in  postings 
and  similar  bookkeeping  data.  He  reads  only  what  is  of  interest 
to  him  and  these  things  are  not. 

The  same  principle  applies  to  the  client  whose  own  accounts 
are  being  reported  upon  by  an  auditor.  The  auditor  secures 
access  to  records  which  the  usual  executive  does  not  see,  and  has  a 
chance  to  observe  the  staff  under  conditions  which  do  not  exist 
when  the  boss  is  around.  This  does  not  contemplate  that  the 
auditor  shall  report  trivial  matters  which  will  make  the  staff 
hostile  without  being  of  any  real  benefit  to  the  client. 

Elsewhere  in  this  book  it  has  been  pointed  out  that  the 
successful  auditor  must  secure  and  retain  the  hearty  co-operation 
of  the  office  staff.     This  fact  is  here  reiterated  as  a  reminder  that 

VOL.  I — 23 


354  AUDITING— GENERAL  PRINCIPLES 

a  report  should  be  a  constructive  document,  helpful  to  the  client's 
staff  as  well  as  to  the  client.  Occasions  may  arise  where  the 
auditor  cannot  prevent  his  report  from  arousing  hostility  on  the 
part  of  the  staff.  If  this  must  be,  let  it  be  because  vital  defects 
are  criticized,  not  trivial  ones. 

Terminology 

It  is  most  important  that  an  auditor  express  his  findings  and 
opinions  in  good,  simple  English.  His  aim  must  be  to  write  so 
clearly  that  his  report  cannot  possibly  be  misunderstood.  He 
will  not  err  if  he  follows  the  simple  language  of  the  Bible  or  of 
Lincoln  and  avoids  the  involved  style  of  Henry  James. 

It  has  been  said  that  accounts  are  the  language  in  which 
business  transactions  are  written.  It  is  incumbent  on  the  auditor 
to  exemplify  the  fact  that  this  language  is  a  simple  one,  and 
readily  understood.  Classics  may  be  read  in  dead  languages,  but 
commonplace  business  history  is  better  understood  if  written  in  a 
live  tongue. 

Figures  in  themselves  are  of  no  value,  but,  correctly  arranged 
and  properly  interpreted,  the  accounts  of  a  business  organization 
furnish  a  basis  for  knowledge  which  is  indispensable  in  the 
successful  conduct  of  any  enterprise. 

The  truth  may  exist  in  a  report  poorly  written,  but  if  it  is  not 
evident  to  any  interested  party,  then  the  language  used  is  not  well 
chosen. 

An  Illustration. — The  following  memorandum  is  submitted 
as  suggestive  only,  but  it  is  more  than  likely  that  it  would  be  read 
through  to  the  end  by  every  man  or  woman  having  an  interest  in 
the  enterprise  in  question. 

Statement  of  Financial  Condition  of  A  and  B 

At  the  Close  of  Business,  December  31,  192 1 

The  total  assets  of  the  firm  on  this  date  amounted  to  $213,333,  con- 
sisting of  the  following  items :  Cash  in  bank,  $9,465 .    This  is  somewhat  less 


CERTIFICATES  AND  REPORTS  355 

than  is  usually  carried,  but  a  number  of  bills  were  paid  on  December  31, 
which  reduced  the  bank  balance  accordingly.  Notes  Receivable,  $8,450. 
These  are  notes  not  yet  due,  and  are  all  believed  to  be  good.  They  can,  if 
necessary,  be  discounted  at  the  bank  and  furnish  additional  funds.  Ac- 
counts Receivable,  $29,416.  These  were  gone  over  carefully  on  December 
31,  and  an  amount  equal  to  all  accounts  long  overdue  was  charged  to 
income  and  carried  to  reserve  for  doubtful  accounts.  They  are  also 
carried  in  a  separate  ledger  and  are  being  carefully  looked  after,  and  a 
fair  amount  will  no  doubt  be  realized  therefrom.  The  sales  for  the  month 
of  December  were  nearly  $20,000,  and,  as  practically  all  sales  are  on  thirty 
days'  time,  it  is  evident  that  collections  are  in  fine  shape. 

Stock  was  taken  on  December  31- and  amounted  to  $39,460.  The 
market  was  somewhat  lower  on  that  date  than  when  most  of  the  goods 
were  purchased,  so,  in  order  to  be  conservative,  the  inventory  was  priced 
at  market.  All  obsolete  and  damaged  stock  was  inventoried,  but  was  not 
valued.  It  is  proposed  to  dispose  of  all  this  dead  stuff  as  soon  as  possible, 
as  it  is  in  the  way,  and  is  the  source  of  constant  expense  and  annoyance. 
The  inventory  sheets  have  been  securely  bound  and  placed  in  the  safe. 

The  insurance  on  stock  aggregates  $45,000,  which  is  about  10  per 
cent  in  excess  of  the  inventory.  The  rate,  however,  is  only  about  40  cents 
since  the  installation  of  the  sprinkler  plant,  and,  as  the  value  of  the  inven- 
tory fluctuates  from  day  to  day,  it  is  considered  advisable  to  cover  a  small 
margin  above  the  estimated  stock.  The  insurance  question  comes  up 
automatically  once  a  week  so  that  we  cannot  be  caught  unawares,  as  was 
the  case  recently  with  the  X  Y  Z  Company. 

In  November,  we  paid  the  insurance  for  an  entire  year  in  advance,  so 
that  on  December  31  the  proportion  prepaid  amounted  to  $762,  which 
is  carried  as  a  current  asset,  because  it  should  be  charged  against  the 
operations  of  1916.  We  also  paid  the  discount  on  the  notes  at  bank  in 
advance  to  the  extent  of  $412,  and  this  is  carried  as  an  asset  in  the  same 
way  as  the  insurance. 

On  a  conservative  basis,  the  furniture  and  fixtures  on  hand  on  Decem- 
ber 31  were  worth  over  $6,000,  but  as  liberal  depreciation  has  been  written 
off  each  year,  this  item  now  stands  at  $3,418.  We  are  carrying  insurance 
for  $6,500,  however,  and  in  case  of  a  fire  there  would  be  no  trouble  about 
adjusting  the  loss  and  proving  our  claim,  as  a  carefully  prepared  schedule 
of  each  article,  with  date  of  purchase  and  cost  price,  is  kept  in  the  safe. 

Our  land  and  buildings  are  now  carried  at  a  net  valuation  of  $84,710, 
made  up  as  follows:  cost  of  land  in  1901,  $50,000;  cost  of  buildings, 
$49,862.  We  have  carried  to  our  reserve  account  annual  depreciation  at 
the  rate  of  4  per  cent  per  annum,  reducing  the  accounts  to  $34,710.    This 


356  AUDITING— GENERAL  PRINCIPLES 

rate  is  probably  too  high,  as  2>^  per  cent  per  annum  is  stated  to  be  the 
proper  rate  of  depreciation  on  buildings  like  ours,  but,  as  the  depreciation 
is  charged  into  the  expenses  every  year,  it  keeps  us  on  the  safe  side  when 
figuring  our  costs,  and,  if  it  should  ever  be  considered  advisable  to  tear 
down  some  of  our  older  buildings,  the  rate  of  depreciation  charged  wiU  be 
justified.  The  machinery  account  now  stands  on  our  books  at  a  net 
valuation  of  $37,240.  The  original  cost  of  the  machinery  now  installed  in 
the  plant  was  over  $60,000,  but  depreciation  at  rates  varying  from  10  to 
20  per  cent  per  annum  has  been  charged  on  the  same  theory  as  with  build- 
ings. Much  of  our  machinery  is  of  a  type  which  is  subject  to  improve- 
ments and  new  inventions,  and,  as  has  been  the  case  in  the  past,  some  so- 
called  modern  machines  may  become  obsolete  overnight.  If  our  machinery 
account  were  carried  on  our  books  at  cost  or  nearly  so,  as  is  done  by  some 
of  our  competitors,  we  would  no  doubt  be  afraid  to  abandon  it  for  fear  of 
the  resulting  shrinkage  in  our  assets,  but  the  liberal  depreciation  charged 
and  the  consequent  margin  in  this  account  permit  us  to  keep  absolutely 
up  to  date  with  our  entire  equipment.  Unquestionably  a  fair  share  of  our 
continued  success  as  manufacturers  is  due  to  this  policy. 

Our  auditors  tell  us  that  they  have  never  examined  the  affairs  of  a  single 
bankrupt  concern  where  the  machinery  account  was  not  inflated  by  reason 
of  insufficient  depreciation  being  written  off,  and  they  point  out  that  the 
moral  is  obvious. 

The  depreciation  on  buildings  and  machinery  is  not  deducted  directly 
from  the  respective  accounts,  but  is  carried  separately  as  a  reserve.  The 
reason  for  this  is  that  in  case  of  fire  we  can  submit  the  cost  of  all  the  build- 
ings and  machinery  to  the  adjusters  and  show  them  the  accounts  in  the 
books.  We  have  a  subsidiary  building  and  machinery  ledger,  which  shows 
each  building  and  each  machine  separately  with  cost  of  installation,  etc. 
The  aggregates  of  the  detailed  items  in  this  ledger  agree  exactly  with  the 
totals  in  the  general  ledger. 

If  a  fire  occurred  it  would  be  a  matter  of  negotiation  as  to  the  deduc- 
tions for  wear  and  tear,  and,  as  the  adjusters  would  be  obliged  to  make 
their  calculations  on  a  basis  of  the  life  of  the  buildings  and  machines  or 
their  replacement  cost,  we  ought  to  realize  a  much  larger  amount  than 
that  shown  in  the  balance  sheet.  This  conservative  valuation  not  only 
means  that  we  are  not  fooling  ourselves,  but  our  banks  realize  that  we  are 
not  fooling  them  and  compliment  us  on  our  method  every  time  it  is  ex- 
plained to  them. 

The  President  of  the  National  Bank  told  us  a  short  time  ago  that  he 
believes  we  can  borrow  a  larger  amount  on  our  statement  as  it  is  made  up 
than  some  concerns  whose  plants  may  have  cost  far  more,  but  whose 


CERTIFICATES  AND  REPORTS  357 

methods  are  not  as  conservative.  The  distrust  occasioned  by  lack  of  con- 
servatisxii  leads  a  banker  to  discount  all  the  assets  ruthlessly,  while  with  us 
they  feel  perfectly  safe  in  relying  on  our  figures  and  ''go  the  limit"  when 
we  ask  for  credit. 

The  assets  referred  to  above  aggregate  at  their  reduced  valuation 
$213,333.  The  total  liabilities  on  December  31  amount  to  $74,493,  leaving 
net  capital  invested  in  the  business  $138,840,  of  which  there  stands  to  the 
credit  of  Mr.  A  $74,910,  and  to  the  credit  of  Mr.  B  $63,930. 

The  liabilities  in  detail  are  as  follows: 

Bills  payable,  $18,500,  consisting  of  three  notes  for  $5,000  each,  and 
one  for  $3,500.  The  former  were  discounted  at  the  National  Bank  and 
are  due  January  25,  February  25,  and  March  25.  The  $3,500  note  was 
discounted  at  the  Citizens  Bank  and  is  due  February  25.  As  our  purchases 
are  increasing,  due  to  the  approach  of  the  busy  season,  these  notes  will 
have  to  be  renewed  and  additional  funds  secured.  Our  line  at  the  National 
Bank  is  now  $40,000,  and  at  the  Citizens  Bank  $25,000.  This  is  more  than 
sufficient  to  carry  us  through  the  season  and  will  enable  us  to  discount 
all  our  bills.  The  unpaid  accounts  payable  for  purchases  on  December  31 
amounted  to  $24,218.  No  bills  are  overdue,  and  all  invoices  carrying  cash 
discounts  have  been  paid. 

The  collections  which  are  sure  are  not  sufficient  to  meet  all  of  our  bills  on 
our  regular  pay  day  (the  20th),  so  $10,000  should  be  borrowed,  say  on  the 
1 8th.    The  accrued  wages  up  to  the  night  of  the  31st  amounted  to  $1,340. 

The  taxes  accrued  to  the  same  date  amounted  to  $435.  This  represents 
a  tax  rate  of  2  per  cent,  which  is  a  decided  advance  over  last  year.  We  are 
unable  to  discern  any  additional  benefits  arising  out  of  the  increase,  and  it 
might  be  in  order  to  suggest  to  the  municipal  authorities  that  it  is  up  to 
them  to  establish  efficiency  and  cost  records  and  justify  the  enormous  sums 
they  are  expending  annually  in  an  apparently  aimless  manner. 

The  only  remaining  liability  is  the  mortgage  for  $30,000  on  the  real 
estate.  As  the  interest  rate  is  5  per  cent  and  as  it  is  not  due  for  three  years, 
no  action  with  respect  to  this  debt  is  suggested. 

The  foregoing  narrative  is  necessarily  colorless  and  lacks  the 
local  flavor  which  can  easily  be  woven  about  the  balance  sheet  of 
a  going  business,  so  that  as  read  solely  by  those  connected  with 
the  particular  undertaking,  one  item  after  another  awakens 
interest  and  stimulates  action  with  respect  to  those  figures  which 
appear  to  be  unfavorable. 

It  is  not  hard  to  imagine  a  state  of  affairs  different  from  that 


358  AUDITING— GENERAL  PRINCIPLES 

described,  and  it  is  quite  within  reason  to  prophesy  that  a  descrip- 
tion of  balance  sheets,  cleverly  written  in  the  manner  described, 
will  lead  to  decisive  action  on  the  part  of  an  executive  regarding 
unfavorable  items,  although  previous  efforts  along  routine  lines 
have  failed.  In  any  event,  it  is  well  worth  trying,  particularly  in 
connection  with  an  income  or  trading  statement,  in  which  com- 
parisons are  important  and  instructive.  An  occasional  witticism 
or  business  *' story"  is  not  out  of  place,  assuming  always  that  a 
proper  diagnosis  has  been  made  of  the  executive  to  whom  the 
report  is  addressed. 

Federal  Trade  Commission  Requirements. — The  Federal 
Trade  Commission,  to  protect  the  public  from  losses  due  to  un- 
reliable promotions  and  prospects  which  were  being  offered  as 
*' high-class  investments, "  adopted  a  form  of  inquiry  blank  which 
new  companies  were  directed  to  fill  out  and  forward  to  the  Stock 
and  Securities  Division  of  the  Commission  at  Washington.  The 
following  information  is  requested  under  the  headings  of  "Prop- 


Properties 

Describe  accurately,  but  briefly,  the  properties  acquired  or  to  be 
acquired,  real  and  personal,  with  all  improvements  or  plant  now  or  to  be 
placed  thereon,  the  amounts  paid  or  to  be  paid  in  money,  stocks,  bonds, 
securities  or  otherwise,  therefor  and  the  actual  value  of  each  portion  or 
parcel  thereof. 

Financial  Condition 

Annex  a  copy  of  the  trial  balance  sheet  and  profit  and  loss  statement, 
prepared  for  the  purpose  of  your  report  hereunder  or  made  up  within 
thirty  days  prior  to  the  date  of  this  notice. 

Attach  a  copy  of  the  last  annual  and  last  quarterly  balance  sheet  and 
profit  and  loss  statement. 

As  to  the  assets  enumerated  therein,  describe  briefly  each  item  and 
state  the  actual  cost  and  the  present  estimated  value  thereof. 

State  the  book  value  of  each  class  of  stock  per  share  and  the  estimated 
actual  value  thereof,  eliminating  all  doubtful,  contingent,  speculative  or 
excessively  valued  assets,  stating  what  is  eliminated  and  why. 


CERTIFICATES  AND  REPORTS  359 

Would  not  the  prospective  stockholder  be  protected  to  a 
greater  extent  if  the  Commission  requested  a  statement  certified 
by  reputable  accountants,  prepared  so  that  the  Commission  could 
determine  the  status  of  the  company?  Undoubtedly,  in  some  in- 
stances such  a  request  might  tend  to  discourage  over-enthusiastic 
or  unscrupulous  promoters  and  save  the  public. 

Scope  of  Report 

Certificates  and  reports,  if  true,  must  be  founded  on  the  work 
which  has  been  done.  A  report  should  be  a  narrative  of  facts.  It 
may  include  a  short  history  of  the  enterprise  under  audit,  par- 
ticularly when  it  is  intended  for  the  perusal  of  those  whose  infor- 
mation on  this  point  is  limited. 

A  certificate  should  be  brief  and  to  the  point  and  should 
embody  conclusions  based  solely  on  the  auditor's  investigations. 

A  report  is  for  the  edification  of  others,  and  therefore  it  is  the 
duty  of  the  auditor  to  make  it  interesting.  The  most  successful 
auditors  pay  much  attention  to  this  aspect  of  their  work;  con- 
sequently, clients  are  glad  to  get  their  reports  and  read  them. 

How  much  space  should  be  given  to  the  detailed  work  done 
by  the  auditor?  The  average  client  does  not  care  how  the  auditor 
arrives  at  his  results — all  he  wants  is  information.  He  asks: 
^' Are  the  accounts  correct,  or,  if  not  correct,  wherein  are  they  in- 
accurate, and  how  shall  they  be  improved?" 

Some  auditors  who  have  not  verified  every  item  on  the  books 
think  that  they  escape  responsibiHty  by  detailing  all  of  the  ground 
covered.  If  work  is  omitted  which  should  have  been  performed, 
a  carefully  worded  report  which  points  out  what  work  was  done 
but  which  omits  any  mention  of  the  work  in  question  cannot  be 
used  by  the  auditor  to  escape  liability. 

Reports  must  be  founded  on  facts  discovered,  verified,  or 
compiled  by  the  auditor,  but  it  is  neither  desirable  nor  necessary 
to  comment  on  immaterial  matters  or  furnish  superfluous 
schedules. 

The  purpose  for  which  the  report  is  to  be  used  must  in  every 


36o  AUDITING— GENERAL  PRINCIPLEvS 

case  be  carefully  considered  before  it  is  written.  For  instance,  a 
prospective  borrower  does  not  want  an  auditor  to  submit  a 
balance  sheet  which  is  accompanied  by  comments  on  the  system 
of  accounts,  nor  does  he  want  long  schedules  of  clerical  errors. 
On  the  other  hand,  it  is  quite  in  order  to  submit  a  balance  sheet 
accompanied  by  qualifying  comments,  provided  the  changes 
which  the  auditor  thinks  should  be  made  in  the  balance  sheet 
figures  are  not  permitted  to  be  made  in  the  books,  or  provided  the 
balance  sheet  items  are  not  sufficiently  self-explanatory.  It  is 
usually  desirable  and  convenient  to  comment  on  balance  sheet 
items  in  the  same  order  in  which  they  appear  on  the  balance  sheet. 

Requirements  Outlined. — Where  balance  sheets  are  not 
designed  for  publication,  the  most  satisfactory  report  consists  of 
the  following: 

Comments  on  the  audit  and  on  the  balance  sheet. 

The  balance  sheet,  supported  by  detailed  schedules  wher- 
ever they  are  necessary  or  deemed  to  be  of  practical  use. 

The  income  statement,  divided  into  sections  or  groups  and 
supported  by  schedules  if  required. 

Special  schedules. 

When  a  report  contains  numerous  comments  it  is  not  necessary 
to  insert  a  formal  audit  certificate  in  the  text.  It  is,  however,  a 
matter  of  taste.  Some  auditors  observe  the  practice  of  commenc- 
ing their  reports  with  formal  certificates,  but  in  most  cases  they 
look  out  of  place. 

Certificate  of  Audit 

The  certificate  should  be  as  short  and  concise  as  possible. 
Attempts  to  qualify  a  certificate  are  not  regarded  with  favor,  and, 
unless  the  scope  of  the  audit  is  greatly  restricted,  it  is  the  auditor's 
duty  to  conform  as  nearly  as  possible  to  the  *' audited  and  found 
correct "  style.  Of  course,  when  quahfications  are  necessary  they 
must  go  in  without  fear  or  favor;  but  the  point  the  author  has  in 


CERTIFICATES  AND  REPORTS  36I 

mind  is  the  evident  fear  of  many  accountants  that  their  certifi- 
cates will  be  taken  seriously  and  acted  upon.  In  this  fear  they 
hedge  themselves  about  with  all  sorts  of  ambiguous  qualifications. 
Sometimes  these  sound  like  arguments,  i.e.,  the  certificate  reads 
in  effect  that  if  so  and  so  were  done,  so  and  so  would  be  the  result. 
Most  business  men  gladly  listen  to  sound  arguments  before  the 
report  is  written,  therefore  changes  recommended  may  as  well  be 
made  in  the  balance  sheet  and  thus  permit  the  giving  of  an  un- 
qualified certificate,  which  is  always  the  most  desirable. 

Illustrations. — Seven  forms  of  certificates  applicable  to  a 
variety  of  conditions  are  shown  below. 

A  form,  variations  of  which  are  used  by  leading  auditors,  is  as 
follows: 

The  Board  of  Directors, 
ABC  Company. 

We  have  audited  the  accounts  of  the  ABC  Company  for  the  year 
ended  December  31,1921. 

We  verified  the  Cash,  the  Inventories  of  Raw  Materials  and  SuppUes, 
Work  in  Progress,  and  Finished  Product,  and  the  other  current  assets  as  of 
December  31,  1921. 

The  Raw  Materials  and  Supplies  on  hand  and  in  process  of  manu- 
facture were  priced  at  cost,  except  that  where  market  values  at  December 
31,  192 1,  were  less  than  cost,  the  inventories  were  reduced  to  market 
values.  Sufficient  reserves  have  been  made  for  probable  losses  on  notes 
and  accounts  receivable. 

We  examined  the  charges  to  capital  accounts  and  find  them  to  represent 
actual  additions  to  the  Company's  property.  Ample  allowances  have  been 
made  for  depreciation  of  plants.  All  known  liabilities  have  been  included 
in  the  accounts. 

We  Hereby  Certify  that  in  our  opinion  the  accompanying  balance 
sheet  and  income  account  correctly  present  the  financial  condition  of  the 
Company  as  of  December  31,  1921,  and  its  operations  for  the  year  ended 
with  that  date. 

(Signed)  X  Y  Z, 

Certified  Public  Accountants. 

If  qualifications  are  necessary,  the  above  form  can  be  used  as 
a  basis  and  the  qualifications  mentioned  in  their  proper  place. 


362  AUDITING— GENERAL  PRINCIPLES 

As  mentioned  heretofore,  some  certificates  require  as  much 
analysis  as  the  figures  themselves.  In  such  cases  it  may  be  better 
to  omit  the  certificate  in  the  annual  report  of  a  corporation,  since 
its  wide  publication,  chiefly  for  those  who  need  simple  rather  than 
complicated  reports,  is  likely  to  do  more  harm  than  good.  The 
following  auditor's  certificate  (with  slight  changes)  was  circulated 
in  July,  192 1,  to  many  thousands  of  stockholders  of  a  large  cor- 
poration. The  balance  sheet  contained  many  details,  yet  the 
certificate  itself  was  about  as  complicated.  The  certificate  was 
substantially  as  follows : 

We  have  audited  the  head  office  books  and  accounts  of  the  A,  B,  and 
C  Companies  at ,  and  of  the  two  independently  operated  sub- 
sidiary companies  at and ,  and  of  D  Company  at 

,  for  the  year  ending  May  31, 1921,  and,  accepting  the  financial 

reports  and  balance  sheets  submitted  to  us  for  all  other  subsidiary  com- 
panies, district  offices  and  branches,  whose  books  we  have  not  audited,we 
find  that  the  above  Consolidated  Balance  Sheet  is  correctly  prepared 
therefrom. 

We  have  scrutinized  the  expenditures  added  to  property  accounts,  and 
are  satisfied  that  the  respective  items  are  of  the  nature  of  actual  additions 
or  permanent  improvements,  and  are  properly  chargeable  to  capital  ac- 
count.  All  expenditures  during  the  year  for  replacements  and  maintenance 

aggregating  $ have  been  charged  against  operations  and  in 

addition  a  further  provision  has  been  made  for  depreciation. 

The  inventories  of  raw  materials  and  manufactured  products  on  hand 
are  valued  at  cost  or  market  price,  whichever  was  the  lower,  and  the  quan- 
tities of  all  inventories  shown  by  the  system  of  cost  accounting  have  been 
confirmed  by  actual  count  or  measurement  as  at  May  31,  1921,  made  by 
responsible  officials. 

The  head  office  cash,  notes  and  other  securities  have  been  verified  by 
actual  inspection  or  certificates  from  depositaries  and  due  provision  has 
been  made  for  all  outstanding  HabiHties  except  possible  additional  federal 
taxes. 

Upon  the  basis  above  indicated,  we  certify  that  in  our  opinion  the  above 
Consolidated  Balance  Sheet  is  a  full  and  fair  statement,  and  is  properly 
drawn  up  so  as  to  show  the  true  financial  position  of  A  Company  and  its 
subsidiary  companies  at  May  31,  192 1. 

(Signed)  J  K  L, 

Certified  PubHc  Accountants. 


CERTIFICATES  AND  REPORTS  3^3 

In  support  of  the  argument  for  a  short  form  of  certificate,  the 
president  of  a  large  bank  wrote  to  the  author  recently,  saying 
inter  alia,  ''We  frequently  observe  certificates  which  require  as 
close  an  analysis  as  the  figures  themselves.  Some  standardized 
form  of  audit  which  would  carry  with  it  all  that  the  word  implies, 
would  be  most  acceptable,  I  think,  to  bankers  generally." 

Where  a  shorter  form  is  required  for  a  certificate  which  is  to 
be  appended  to  the  condensed  balance  sheet  used  by  note-brokers 
and  others,  the  following  is  acceptable: 

We  have  audited  the  accounts  of  the  D  E  F  Company  for  the  year 
ended  November  30,  1921,  and 

We  Certify  that  the  above  balance  sheet  and  income  account  agree 
with  the  books  and  in  our  opinion  correctly  set  forth  the  financial  condition 
of  the  Company  as  of  November  30,  192 1. 

(Signed)  R  S  T, 

Certified  Public  Accountants. 

A  form  of  certificate  suggested  in  "Uniform  Accounting,"  a 
tentative  proposal  submitted  by  the  Federal  Reserve  Board,  etc., 
is  as  follows : 

I  have  audited  the  accounts  of  Blank  &  Co.  for  the  period  from 

to and  I  certify  that  the  above  balance  sheet  and  statement  of 

profit  and  loss  have  been  made  in  accordance  with  the  plan  suggested  and 
advised  by  the  Federal  Reserve  Board  and  in  my  opinion  set  forth  the 
financial  condition  of  the  firm  at and  the  results  of  its  opera- 
tions for  the  period. 

The  following  forms  are  also  used : 

We  have  examined  the  accounts  of  the  ABC  Company  as  of 

192 . .  and  certify  that,  in  our  opinion,  the  above  balance  sheet  correctly 
sets  forth  the  Company's  financial  position  at  that  date. 

(Signed)  D  E  F, 

Accountants  and  Auditors. 

We  have  made  an  examination  of  the  accounts  of  the  ABC  Company 
and  its  subsidiary  companies  as  at 192 . .  and  (subject  to  the 


364  AUDITING— GENERAL  PRINCIPLES 

valuation  of  plants  and  trade-marks  being  correct)  we  certify  that  in  our 
opinion  the  above  consolidated  balance  sheet  and  the  accompanying  state- 
ment of  earnings  set  forth  correctly  the  financial  condition  of  the  corpora- 
tion and  its  subsidiaries  at  that  date,  and  their  operations  for  the  year 
then  ended. 

(Signed)  X  Y  Z, 

Accountants  and  Auditors. 
New  York 192. . 


We  have  audited  the  accounts  of  A  Company  for  the  year  ended 

The  cash  in  banks  was  verified  by  certificates  from  the 

depositaries.  The  accounts  receivable  were  verified  from  the  Company's 
books  and  examined  as  to  their  collectibility.  The  inventories  have  been 
certified  to  us  as  to  quantity  by  responsible  officials  of  the  Company,  and 
have  been  ascertained  by  us  to  have  been  valued  at  not  more  than  cost. 

Ample  reserves  have  been  made  for  depreciation  of  plant.  No  ex- 
penditures have  been  charged  to  the  plant  during  the  year  which  were  not 
for  actual  additions  or  improvements. 

From  its  accumulated  net  profits,  the  Company  paid,  in ,  the 

sum  of  $ into  its  First  Preferred  Stock  Sinking  Fund,  to  meet  the 

requirements  of  its  Certificate  of  Incorporation.     First  Preferred  Stock 

to  the  extent  of  $ par  value  was  canceled  through  the  operation 

of  this  Sinking  Fund. 

We  Hereby  Certify  that,  in  our  opinion,  the  accompanying  balance 

sheet  of ,  is  a  correct  statement  of  the  A  Company's  financial 

condition  at  that  date  and  that  the  accompanying  income  account  cor- 
rectly summarizes  the  results  of  the  business  for  the  year  ended. 

(Signed)  B,  C  and  D, 

Certified  Public  Accountants. 
(Date) 

''As  of"  Date  of  Balance  Sheet. — The  question  sometimes 
arises,  how  to  submit  a  balance  sheet  and  report  thereon  when  the 
audit  is  made  so  long  after  the  balance  sheet  that  adjustments 
cannot  be  made  as  of  that  date,  and  when  the  auditor  cannot 
certify  that  the  balance  sheet  "agrees  with  the  books  and  is 
correct."  The  best  way  is  to  have  the  entries  journalized  before 
the  report  is  written,  and,  no  matter  how  long  after  the  date,  the 
entries  should  read  "  as  of "  the  date  of  the  balance  sheet.    When 


CERTIFICATES  AND  REPORTS  3^5 

posted  to  the  ledger  the  items  should  be  connected  with  the 
closing  date  by  means  of  a  star  or  asterisk.  Subsequent  trial 
balances  and  any  subsequent  references  will  then  find  the  ac- 
counts in  order,  and  there  can  be  no  difficulty  if  it  becomes 
necessary  to  reconcile  them  with  the  balance  sheet. 

Wherever  the  auditor's  recommendations  as  to  adjustments  of 
asset  or  liability  items  are  not  or  cannot  be  adopted  and  recorded 
"as  of"  the  date  of  the  balance  sheet,  the  most  satisfactory  form 
of  report  thereon  is  to  submit  the  balance  sheet  as  shown  by  the 
books  and  precede  this  with  comments  which  should  be  bound 
with,  and  permanently  attached  to,  the  balance  sheet,  so  that 
improper  use  cannot  be  made  of  the  balance  sheet  by  removing 
the  qualifying  comments. 

Use  of  Watermarked  Paper. — Clients  do  not  always  appre- 
ciate the  position  of  an  auditor  with  respect  to  the  use  of  balance 
sheets.  Experience  shows  that  they  frequently  hope  for  a  more 
favorable  statement  than  they  receive,  and  since  the  audit  may  be 
for  the  purpose  of  securing  credit,  an  unfavorable  statement 
places  the  client  in  an  embarrassing  position.  Auditors  must 
always  be  on  guard,  therefore,  to  see  that  balance  sheets  made  up 
by  them  and  subject  to  qualification  are  not  submitted  in  such  form 
as  will  admit  of  their  being  separated  from  such  qualifications. 

Basing  his  opinion  on  long  experience  of  his  own  and  other 
firms,  the  author  believes  that  the  only  safe  method  of  reporting 
is  to  use  paper  bearing  one's  own  watermark.  This  is  not  very 
expensive  when  a  considerable  quantity  of  paper  is  used. 

If  an  auditor  is  able  to  construct  his  own  balance  sheet  and  can 
certify  thereon  that  it  is  correct,  it  does  not  make  any  difference 
whether  or  not  it  is  separated  from  the  comments.  In  fact,  it  is  usu- 
ally preferable  to  submit  such  a  balance  sheet  complete  in  itself. 

Form  of  Balance  Sheet 

Many  tiresome  pages  have  been  written  explaining,  or  trying 
to  explain,  why  it  is  that  universal  American  custom  decrees  that 


366  AUDITING— GENERAL  PRINCIPLES 

assets  shall  be  placed  on  the  left-hand  side  of  the  balance  sheet  and 
.liabilities  on  the  right-hand  side.  The  explanation  is  no  more  satis- 
factory than  the  reasons  advanced  by  English  authorities  to  support 
their  custom  of  placing  liabilities  on  the  left  and  assets  on  the  right. 

The  author  ventures  the  following :  - 

The  English  practice  is  purely  the  outcome  of  custom.  A  long 
time  ago  someone  started  that  way  and  everyone  since  has  fol- 
lowed, until  now  the  form  has  the  sanction  of  law.  The  only 
sound  reason  the  author  can  think  of  for  the  custom  is  that  a  con- 
servative Englishman  looks  for  his  liabilities  first  and  then  looks 
to  see  if  he  has  enough  assets  to  discharge  them. 

In  the  United  States,  accountancy  has  developed  more  scien- 
tifically than  in  England.  If  a  short  cut  is  logical  we  take  it. 
When  it  was  found  that  loose  leaves  were  far  more  convenient 
and  economical  to  handle  than  leaves  bound  permanently  togeth- 
er, we  adopted  them.  So  with  balance  sheets.  It  was  observed 
by  accountants  that  the  average  American  looks  for  his  assets 
first  and  subsequently  glances  at  his  liabilities  in  order  to  assure 
himself  that  his  excess  of  assets  is  as  much  as  he  believes  it  to  be. 

Furthermore,  it  is  common  sense  for  a  man  who  decides  to  re- 
cord his  financial  condition  to  place  his  possessions  first.  Frequent- 
ly a  man  has  few  or  no  liabilities,  so  that  the  practice  of  stating  the 
assets  first,  then  the  liabilities,  if  any,  as  a  deduction  therefrom, 
thus  arriving  at  the  surplus,  is  the  logical  presentation  applicable 
to  the  great  majority  of  business  enterprises  in  the  United  States. 

Account  Form  of  Balance  Sheet. — What  may  be  styled  the 
account  form  of  balance  sheet  is  one  with  the  assets  on  the  left 
and  the  liabilities  and  net  worth  on  the  right.  This  permits  an 
agreement  between  the  totals  of  the  two  sides.  Sometimes  a 
deficit  exists  and  the  bookkeeper's  passion  for  making  things 
balance  is  so  strong  that  the  deficit  is  included  among  the  assets ! 
The  almost  incredible  result  is  that  practically  all  published 
balance  sheets  consist  of  a  confusion  of  figures  on  both  sides  which 
exactly  agree  in  total.    The  reader  thereof  who  is  not  trained  in 


lTES 


CERTIFICATES  AND  REPORTS  3^7 

accounts  does  not  comprehend  the  details,  but  he  is  reassured  in 
some  mysterious  way  when  he  finally  discovers  that  the  liabilities 
at  least  do  not  exceed  the  assets. 

An  Ideal  Balance  Sheet. — The  author's  conception  of  an 
ideal  balance  sheet  is  one  which  sets  forth : 

1.  The  assets,  properly  valued  and  grouped,  and  arranged  in 
the  order  of  their  availability. 

English  law  and  custom  may  be  against  this  form,  but  never- 
theless it  is  the  most  readable  and  the  most  understandable  to 
the  average  business  man.  Furthermore,  it  has  the  sanction  of 
the  bankers  and  credit  men  of  this  country,  who  use  balance 
sheets  more  often  than  any  other  class  of  men.^ 

2.  The  liabilities  also  properly  grouped  and  arranged  in  the 
order  in  which  they  will,  or  should,  be  discharged. 

3.  If  possible,  the  excess  of  the  assets  or  the  liabilities  should 
next  be  shown,  in  ord^r  that  the  net  worth  or  capital  of  the  enter- 
prise may  be  clearly  apparent  to  anyone  interested. 

4.  A  statement  showing  to  whom  the  excess  belongs  or  from 
whom  it  is  due.  That  is,  if  a  corporation,  there  should  be  shown 
the  capital  stock  issued,  the  addition  thereto  if  a  surplus  of  assets 
exists,  or  the  deduction  therefrom  if  there  is  a  deficiency. 

These  concepts  are  illustrated  in  the  following  form : 

Assets 

Current  Assets: 

Cash $...... 

Notes  and  Accounts  Receivable 

Inventories 

Prepaid  Insurance,  etc ,     $ 

Deferred  Charges: 

Bond  Discount,  etc , 

Plant  Assets: 

Real  Estate $..M.. 

Machinery,  Fixtures,  etc .'. 

Good-Will,  Patents,  etc . . . ;  >. 


See  official  forms,  pages  372-373,  378,  382,  387,  389,  391,  395. 


368 


AUDITING— GENERAL  PRINCIPLES 


Liabilities 

Notes  Payable $ . 

Accounts  Payable 

Accrued  Wages 

Reserves  (not  deductible  from  assets) 

Bonded  Debt 


Excess  of  Assets 
{Or  Net  Worth)  ^^ 

Capital  Stock $ 

Surplus  (or  Deficit) '..(.. 


^ 


Popular  Forms  of  Balance  Sheets. — Among  large  indus- 
trial corporations  which  publish  their  balance  sheets,  the  most 
popular  form  is  as  follows : 


Assets 

Liabilities 

Plant  Assets: 

Capital  Stock 

$ 

(Including  Real  Estate, 

Bonded  Debt 

Machinery,     Patents, 

Current  Liabilities: 

Good- Will,  etc.) 

$ 

Notes  Payable     $ 

Deferred  Charges  to  Opera- 

Accounts Pay- 

tions : 

able 

Insurance,  Interest,  etc., 

Accrued  Wages, 

Prepaid 

etc 

Current  Assets: 

Reserves 

Inventories ....     $ 

Surplus 

Accounts     and 

Notes  Receiv- 

able  

Cash 

$ 

$ 

The  above  arrangement  is  not  easy  reading  for  one  unaccus- 
tomed to  accounts,  moreover  it  presupposes  that  the  reader  can 
discriminate  between  actual  liabilities  and  surplus.  The  inclu- 
sion of  surplus  under  a  caption  which  is  misleading,  is  unfortunate, 
especially  when  such  procedure  is  unnecessary. 

The  following  form  is  preferable: 


CERTIFICATES  AND  REPORTS 


369 


o  o 
o  q 
6  6 

o  o 
o  o 


0.2 


i>0 
53 


2 

a" 


o  X 


^2    '^2 

'-' «  o  u 

^  O  o  o 

u 


o  0000 

o  0000 

o  9.  o_  q  o_ 

o  6  6  6  6 

O  O  O  >/50\ 


0)   (U 

^t    ■ 
^^-  '■ 

-"r"   "   .,   o 


«  rt  a;  v-.rt 
M-.  «  rt  -^^  -Ss  ^3 


VOL.  1 — 24 


370  AUDITING— GENERAL  PRINCIPLES 

It  is  asserted  that  there  is  a  demand  for  the  form  of  balance 
sheet  given  on  page  368  from  those  whose  chief  desire  is  to  see  the 
relation  of  the  fixed  assets  to  the  capital  stock.  But  this  infor- 
mation can  be  more  readily  secured  from  the  above  form,  because 
where  fixed  items  appear  first  it  is  usual  to  place  the  capital  stock 
first  among  the  liabilities  and  the  surplus  last.  Since  the  surplus 
may  be  as  large  as  or  larger  than  the  capital  stock,  it  is  very 
necessary  to  have  these  figures  in  juxtaposition,  as  provided  in 
the  second  form. 

It  is,  of  course,  impossible  to  mention  by  name  the  assets  and 
liabilities  which  are  found  in  different  enterprises;  therefore  these 
outline  forms  must  be  considered  as  suggestive  only.  In  other 
chapters  of  this  book  is  pointed  out  the  importance  of  the  audi- 
tor's placing  himself  as  nearly  as  possible  in  the  position  of  the 
one  who  is  to  use  the  accounts.  It  is  hoped  that  these  sugges- 
tions will  be  more  helpful  in  framing  a  balance  sheet  than  would  a 
set  form  which  might  apply  in  a  few  cases,  but  which  would  be 
restrictive  and  therefore  of  little  value  in  others. 

One  general  principle  which  should  be  observed  in  all  balance 
sheets  is  that  the  matter  of  the  arrangement  of  the  groups  is  not 
of  so  much  importance  as  is  the  relation  of  one  to  another.  That 
is,  it  does  not  greatly  matter  whether  the  fixed  assets  are  placed 
first  or  last,  but  it  is  important  that  the  balance  sheet  shall  indicate, 
if  possible,  the  relation  of  the  fixed  assets  to  the  other  assets  and 
to  the  liabilities.  For  instance,  a  concern  owning  a  million  dol- 
lars of  fixed  assets  should  have  a  capital  and  surplus,  or  funded 
debt,  of  at  least  as  much,  otherwise  the  current  liabilities  would 
be  excessive. 

Proposal  of  Federal  Reserve  Board. — On  pages  372  and 
373  is  a  balance  sheet  form  suggested  in  191 7  by  the  Federal  Re- 
serve Board,  as  a  tentative  proposal,  in  "Uniform  Accounting.'' 

In  this  form  the  item  ''deferred  charges"  is  not  included 
in  current  assets;  no  provision  is  made  for  the  segregation  of 
items  such  as  stripping  costs  in  a  mine,  bond  discounts,  etc. 


CERTIFICATES  AND  REPORTS  371 

In  modern  practice  deferred  charges  appear  in  their  proper  place 
in  the  balance  sheet.  ^  Instead  of  showing  good- will  as  an  asset, 
the  book  value  is  deducted  from  capital.  The  suggestion  is 
unique.  No  doubt  the  intention  was  to  show  net  worth  exclu- 
sive of  good- will.  The  suggestion  does  not  accord  with  the  usual 
practice.  In  a  later  (192 1)  Federal  Reserve  form^  good-will 
appears  among  the  assets. 

Comparative  Value  of  Condensed  and  Detailed  Forms. 
— The  condensed  forms  of  balance  sheets  shown  on  pages  367  and 
369  illustrate  the  order  in  which  the  assets  and  liabilities  should 
be  stated,  but  do  not  convey  as  much  information  as  should 
be  furnished;  the  more  detailed  form  suggested  by  the  Federal 
Reserve  Board  is  preferable.  There  is  some  reluctance  on  the 
part  of  corporations  to  the  use  of  the  complete  form;  but  credi- 
tors and  stockholders  are  entitled  to  balance  sheets  which  tell 
the  whole  story,  and  within  reasonable  limits  they  should  demand 
more  complete  information  than  is  found  in  the  ordinary 
condensed  balance  sheet. 

Contingent  Liabilities. — From  an  accounting  standpoint 
there  are  four  different  ways  of  showing  contingent  liabilities  on 
the  balance  sheet.  Method  one,  which  is  the  best  where  practical, 
is  to  show  the  contingent  liability  as  a  contra  item  to  the  corre- 
sponding contingent  asset.  For  instance,  when  notes  receivable 
are  discounted,  a  corresponding  amount  of  cash  (less  discount) 
is  received.  Instead  of  omitting  mention  of  the  notes  receivable, 
they  should  be  retained  upon  the  balance  sheet  as  a  contra  item 
to  notes  receivable  discounted  upon  the  liability  side,  both 
amounts  affecting  the  balance.  A  second  method  is  to  show  gross 
amount  of  the  notes  receivable  and  deduct  from  them  the 
amounts  which  have  been  discounted,  showing  the  net  amount 
on  the  assets  side  of  the  balance  sheet.  A  third  method  is  to  omit 
mention  of  the  notes  receivable  which  have  been  discounted  but 


*  See  page  115. 
3  See  page  387. 


372  AUDITING— GENERAL  PRINCIPLES 

Federal  Reserve  Bo  are 


Assets 


Cash: 

la.    Cash  on  hand — currency  and  coin, 
lb.   Cash  in  bank 


Notes  and  accounts  receivable: 

3.   Notes  receivable  of  customers  on  hand  (not  past  due). .  . 
5.   Notes  receivable  discounted  or  sold  with  indorsement 

or  guaranty 

7.  Accounts  receivable,  customers  (not  past  due)  .  .  ...  .  . 

9.   Notes    receivable,  customers,  past    due   (cash    value, 

$••••) 

II.  Accounts  receivable,  customers,  past  due  (cash  value, 
$••■■)  


Less: 

13.  Provisions  for  bad  debts 

15.  Provisions  for  discounts,  freights,  allow- 
ances, etc 


Inventories: 

17.  Raw  material  on  hand 

19.  Goods  in  process 

21.  Uncompleted  contracts 

Less  payments  on  account  thereof 

23.  Finished  goods  on  hand 

Other  quick  assets  (describe  fully) : 


Total  quick  assets  (excluding  all  investments) 

Securities : 

25.  Securities  readily  marketable  and  salable  without  im- 
pairing the  business 

27.  Notes  given  by  officers,  stockholders,  or  employees  ,  .  . 
29.  Accounts  due  from  officers,  stockholders,  or  employees. 


Total  current  assets . 


Fixed  assets: 

31.  Land  used  for  plant 

33.  Buildings  used  for  plant 

35.  Machinery 

37.  Tools  and  plant  equipment 

39.  Patterns  and  drawings 

41.  Office  furniture  and  fixtures 

43.  Other  fixed  assets,  if  any  (describe  fully) 


Less: 

45.  Reserves  for  depreciation  , 


Total  fixed  assets 


Deferred  charges: 

47.   Prepaid  expenses,  interest,  insurance,  taxes,  etc 
Other  assets  (49) 


Total  assets . 


CERTIFICATES  AND  REPORTS  373 

Form  of  Balance  Sheet 

Liabilities 

Bills,  notes,  and  accounts  payable: 
Unsecured  bills  and  notes — 

2o  Acceptances  made  for  merchandise  or  raw  material 

purchased 

4.  Notes  given  for  merchandise  or  raw  material  pur- 
chased   

6.  Notes  given  to  banks  for  money  borrowed 

8,  Notes  sold  through  brokers 

10.  Notes  given  for  machinery,  additions  to  plant,  etc. 

12.  Notes  due  to  stockholders,  officers,  or  employees »... 


Unsecured  accounts — 

14.  Accounts  payable  for  purchase  (not  yet  due) 

16.  Accounts  payable  for  purchases  (past  due) 

18.  Accounts  payable  to  stockholders,  officers,  or  em- 
ployees   

Secured  liabilities — 

20a.  Notes  receivable  discounted  or  sold  with  indorse- 
ment or  guaranty  (contra) 

20b.  Customers'     accounts    discounted    or    assigned 

(contra) 

20c.  Obligations  secured  by  liens  on  inventories 

2od.  Obligations  secured   by   securities   deposited   as 
collateral 


22o     Accrued  liabilities  (interest,  taxes,  wages,  etc.). 
Other  current  liabilities  (describe  fully) : 


Total  current  liabilities , 


Fixed  liabilities : 

24.  Mortgage  on  plant  (due  date ) 

26.  Mortgage  on  other  real  estate  (due  date )  .  . . . 

28.  Chattel  mortgage  on  machinery  or  equipment   (due 

date ) 

30.  Bonded  debt  (due  date ) 

32.  Other  fixed  liabilities  (described  fully): 


Total  liabilities , 


Net  worth: 

34.  If  a  corporation — 

\a)  Preferred  stock  (less  stock  in  treasury), 
>)  Common  stock  (less  stock  in  treasury)  . 
;)  Surplus  and  undivided  profits 


Less: 


[^ 


Book  value  of  good-will . 
Deficit 


36.  If  an  individual  or  partnership — 

ia)  Capital 

(b)  Undistributed  profits  or  deficit . 

Total 


374  AUDITING— GENERAL  PRINCIPLES 

to  indicate  the  notes  receivable  discounted  as  a  contingent  lia- 
bility on  the  liability  side,  and  write  the  amount  short  to  indicate 
that  they  have  not  been  included  in  the  total.  A  fourth  method, 
probably  the  simplest  and  most  useful  of  all,  is  to  asterisk  the 
notes  receivable  and  call  attention  in  a  footnote  that  a  certain 
proportion  of  notes  receivable  (stating  the  exact  amount)  have 
been  discounted. 

Reserves  Must  Be  Segregated  prom  Surplus. — As  stated 
elsewhere,  reserves  (other  than  those  representing  mere  subdivi- 
sions of  surplus)  should  be  deducted  from  assets  or  included 
among  liabilities;  any  other  treatment  is  grossly  misleading.  In 
a  form  of  balance  sheet  published  by  the  Cleveland  Clearing 
House  Association  there  are  two  groups  of  liabilities,  viz.:  (a) 
current,  and  (b)  a  general  group  which  includes  bonded  debt  and 
^'any  other  liabilities."  The  two  groups  are  aggregated  under 
the  caption  ''total  Habihties."  Surely  a  reader  of  the  balance 
sheet  would  be  justified  in  assuming  that  the  deduction  of  ''total 
liabilities"  from  total  assets  would  produce  net  worth;  but  such 
is  not  the  case.  Further  down  in  the  balance  sheet  after  the 
caption  "total  liabilities"  appears  a  caption  "reserves."  The 
form  is  a  very  bad  one  as  it  improperly  induces  the  concerns 
which  use  it  to  overstate  net  worth.  The  seeker  of  credit  using 
the  official  form  mentioned  can  hardly  be  criticized  if  he  hesitates 
to  deduct  reserves  from  assets  or  fails  to  include  them  among 
liabilities. 

Comparing  Assets  and  Liabilities. — Opposite  is  shown  a 
form  of  balance  sheet  which  purports  to  bring  out  comparisons 
of  current  assets  and  liabilities,  and  so  on.  It  is  not  a  bad  form 
if  properly  used;  but  the  large  item  of  current  Habilities  which  is 
inserted  between  capital  stock  and  surplus,  instead  of  being 
included  among  other  current  liabilities,  is  apt  to  deceive  those 
who  use  the  balance  sheet. 

Surplus — No-Par  Value  Stock. — In  case  of  no-par  value 
stock  it  is  important  that  capital  surplus  and  earned  surplus  be 


CERTIFICATES  AND  REPORTS 


375 


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376  AUDITING— GENERAL  PRINCIPLES 

separated.  The  current  annual  report  of  a  large  corporation 
shows  no-par  value  stock  "declared  at  $5  per  share";  surplus  is 
given  at  $126,369,005.75.  The  net  profit  for  the  year  is  stated 
to  be  $16,179,939.21.  As  the  corporation  had  only  been  organized 
one  year  it  is  obvious  that  a  very  large  part  of  the  surplus  is 
capital  surplus.  The  balance  sheet  is  not  understandable  be- 
cause capital  and  earned  surplus  are  not  separated.  In  order  to 
show  the  true  status  of  affairs  it  is  necessary  to  segregate  capital 
stock,  capital  surplus,  and  earned  surplus.  Usually  the  state 
laws  require  that  a  minimum  value  be  ascribed  to  no-par  value 
shares,  irrespective  of  the  number  issued.  Bearing  this  in  mind 
the  arrangement  of  these  items  in  the  balance  sheet  should  be 
essentially  as  is  shown  below: 

Stock  of  No-Par  Value: 

shares  authorized  at  $ . .  per  share. 

shares  issued. 

Capital  Surplus 

This  item  should  represent  the  excess  of  assets  over  liabilities 
at  the  formation  of  the  company,  plus  or  minus  capital 
gains  or  losses.    Changes  in  capital  surplus  occurring  after 
incorporation  should  be  shown  on  the  balance  sheet. 
Earned  Surplus 

This  should  show  the  net  result  of  operations  after  incorpora- 
tion. 

Treatment  of  Debts  Subordinated. — When  large  stock- 
holders (or,  in  case  of  partnerships,  when  partners)  advance 
funds  which  are  not  intended  to  be  capitalized,  it  is  fairly  com- 
mon to  subordinate  such  loans  to  all  other  creditors.  When  this 
is  done  there  should  be  a  distinct  segregation  in  the  balance  sheet 
in  order  that  the  concern  may  get  the  full  benefit  of  its  reduced 
liabilities  as  compared  with  other  creditors. 

Balance  Sheet  Adjusted  to  New  Capital. — Sometimes 
balance  sheets  are  pubHshed  ''giving  effect  to  new  capital  to  be 
suppHed."  When  this  is  done  the  auditor  must  be  sure  that  the 
capital  has  been  underwritten  by  responsible  parties  and  that 


CERTIFICATES  AND  REPORTS  377 

legal  steps  have  been  taken  to  retire  old  liabilities,  etc.     He  must 
include  the  net,  not  the  gross,  proceeds  of  the  new  issue. 

British  practice  seems  to  be:  (i)  to  set  up  assets  as  at  the  last 
closing  date,  deduct  the  liabilities,  and  to  the  balance  to  add 
'^proceeds  of  present  issue  after  payment  of  purchase  price";  or 
(2)  to  add  the  proceeds  of  the  issue  to  the  assets  before  deducting 
the  liabilities. 

Statement  Required  by  Banks 

For  some  years  bankers  have  required  borrowers  to  furnish 
statements  of  their  assets  and  liabilities.  At  first  a  uniform 
statement  was  not  insisted  on,  but  it  was  found  that  some  bor- 
rowers were  disinclined  to  submit  full  reports  while  others  did  not 
know  what  details  the  banker  wanted.  Individual  banks  there- 
upon compiled  their  own  forms  and  furnished  blanks  to  their 
customers.  These  blanks  were  by  no  means  uniform,  and  since 
many  borrowers  used  more  than  one  bank,  the  diversity  became 
a  nuisance  to  both  banks  and  borrowers.  The  former,  in  ex- 
changing credit  information  with  other  banks,  found  comparisons 
difficult,  and  the  latter  were  put  to  unnecessary  trouble  in 
arranging  and  rearranging  their  statements. 

American  Bankers'  Association  Form. — Finally  an  at- 
tempt was  made  through  the  various  bankers'  associations  to 
formulate  a  uniform  or  standard  blank  which  would  embody  the 
information  most  useful  to  banks.  The  form  on  pages  378  to 
380  is  that  designed  and  officially  approved  by  the  American 
Bankers'  Association. 

Need  of  Proper  Audits. — To  a  professional  auditor,  the 
provision  in  the  form^  for  a  statement  by  the  borrower  whether  or 
not  the  books  have  been  audited  by  a  certified  pubHc  accountant 
is  of  particular  interest.  This  question  was  suggested  by  the  late 
James  G.  Cannon,  of  New  York  City,  who  for  many  years  advised 
bankers  to  employ  professional  auditors  more  generally. 

Unfortunately  for  both  bankers  and  auditors,  the  former 


378 


AUDITING— GENERAL  PRINCIPLES 


f«M  w«.  t^ct>UOtA.tib*-n»Mbmt*f  m  UttAttiL 


fOtU  DES(CN£D  AND  APPAOVCD  BY  THl 
AMERICAN  BANKERS  ASSOCIATION. 


to. 


For  the  purpose  of  procuring  ind  mainUitung  credit  from  time  to  time  in  any  form  whatsoever  with  the  above  named  Bank,  for 
daiAs  and  demands  against  the  undersigned,  the  undersigned  submits  the  following  as  being  a  true  and  accurate  statement  of  its  financial  condi' 
tion  on  the  following  date,  and  agree  that  if  any  change  occurs  that  materially  reduces  the  means  or  ability  of  the  undersigned  to  pay  all  claims 
or  demands  against  it;  the  undersigned  will  immediately  and  without  delay  notify  the  said  Bank ,  and  unless  the  Bank  is  so  notified  it  may  continue 
(0  rely  upon  the  statement  herein  given  as  a  true  and  accurate  statement  of  the  financial  condition  of  the  undersigned : 

Condition  shown  by books  and  inventory  of 19 . 


ASSETS 

LIABILITIES. 

Cash  on  hand  and  in  bank,       

Accounts  of  customers  (good), 

Acceptances: 

Notes  and  acceptances  of  customers  (good),    •    - 

(1)    Issued  in  payment  for  merchaodise,    • ' 

Merchandise  (at  cost) : 

(2)    Other  accepunces, 

(1)    Manufactured.    -    -    • 

Notes  payable  for  merchandise.     ...... 

(2)    Raw  material,    -    -    - 

Notes  payable  to  own  banks. 

(3)    Stock  in  process,     -    - 

Notes  sold  through  brokers, - 

Notes  payable   to   others, -    - 

Total  quick  Ssseti.    -    -    - 

Notes  and  accounts  due  to  us  by  controlled  or 

Money  on  deposit  with  us, 

allied  concerns,      ...•..-..-. 

Notes  and  accounts  due  by  ta  to  omtroUed  or 

Plant  and  machinery,      i.    ..-»•-    • 

aUied  concerns,      ...--^-.-- 

Furniture  and  fixtures,      • 

Other  current  debU  (itemized) 

Othtr  assets  (itemized) 

Total  current  liabUiUes,      ....... 

Bonded  debt— when  due , 

Common,      ..--•. 

Surplus, - 

Notes  rtceivabU  ami  aaiptances  discounted  or  sold 
with  endorsement  or  fuarantee  (contingent  Ua- 

biHiy). 

" 

TOTAL.     -    - 

TOTAL, -    - 

_ 

^ 

Condensed  Profit  and  Loss  Statement  for  the  Fiscal  Year  Ending.;. 


Cost  of  material  or 

Actual  expense  of  conducting  business. 


etc.. 


Salaries  paid  to  officers,  -..••. 
Interest  on  borrowed  money  and  bonds,  - 
Bad  debts  charged  ofl,  -  -  -  -  .  • 
Depreciation  charged  ofi,    .    .    -    .    . 

Net  profits,  -.."- • 

TOTAL, -    -    - 


Net  sa 

From 

From  discounts  on 

From   other  sources   (itemize). 


Undivided  surplus  at  dote  of  previous  fiscal  year, 
Less  charges  not  applicable  to  current  year,  • .    • 

Add  net  profits  as  above, 

Less  dividends  Preferred  ( — ~ — ~ — per  cent), 
LcM  dividends  Common  ( per  cent), 


RECONCILEMENT  OF  SURPLUS. 

$ 

$■    ' 


$• 

». 

$. 


(See  Reverse  Side.) 


CERTIFICATES  AND  REPORTS  379 

CONTINGENT  LIABILITY.— We  have  no  tomingent  Utbility  of  any  Undts  cndoner  or  guutntor  not  noted  slwve  (cxccpi  •$  (oU6«i): 


Plant,  buQding  and  macbinery,  $.. 


LiR  insunmoe  for  benefit  of  company  amounta  to  $- 


None  of  the  accounts  or  notes  receivable  in  the  within  itatement  have  been  assigned,  pledged  or  dixounted  (except  as  follows) : 


Neither  have  any  of  our  other  aoeu  been  pledged  or  asaigned  as  colbteral  for  any  of  our  liabilities  (except  as  follows) : _ 


Assets  on  which  mortgages  and  bonds  are  a  lien..-.- -.__ 

Our  company  is  incorporated  under  the  laws  of  the  Sute  of.. 


We  have  no  interest  in  any  other  concern  except  (name  affiliations  and  location).. 


There  are  no  suits  pending  against  us  (except).. 


The  form  of  obligation  used  in  the  financing  of  pur  business  is  our  plain  note  (endorsed  by)  - 
None  of  the  endoisen  guarantee  or  endorse  the  paper  of  other  concerns  or  individuals  (except) 


Outside  resources  of  endotsen  are , 

.0«{  ^'SS^c^S^**  }  P""^  "»~^  (""«  ''^*er  or  brokew).. 


Our  books  } ":  °    { audited  by  a  certified  public  accountant. 


The  date  of  Ust  audit  was.... „ _made  by 


BANK  ACCOUNTS  LINES  GRANTED  Under  Discount  on  Statement  Date 


Principal  Creditors  Refeieoccs 


OniCERS  AND  DIRECTORS 


..Vice-President. 


^ . ; .Secretary. 

(Please  sign  bere)..^ 


Date  signed ,..,..,...,„.,.,._«., ,. By., 


380 


AUDITING— GENERAL  PRINCIPLES 


ASSETS                                                1 

LIABILITIES 

Cash 

Bills  Rbcbivable  inn) 

ACCOUNTS  Recbivablb  (nbt) 

Mbhchandub 

J.ABD 

Buildinob 

MaCHINBBV— FiXTOBBB 



.... 

NOTKS  Payable 
Accounts  Pavabui 
Deposits 
UoNDED  Debt 

MOETGAOES 
ACCBUED   LUBILmiB 

TOTAL 
Capital 

Surplus— Paoms 
Rkskbves 

TOTAL 

.... 

.... 



.... 

::*':: 

•.'.. 

TOTAL 

1           1           \ 

CONTINGENT  LIABILITIKS.    On  bUla  recsivable  diaceonted Other 

CASH.    On  hand  and  In  bank,  | NkmeB  of  bwika , 

BILLS  RECEIVABLE.    Any  overdue  or  doubtful ! Any  from  officerB,  directors,  •ubHiompanles,  cr  ilrollar  sources 

ACCOUNTS  RECEIVABr.E.  Rutc  BmoDot  doubthil,  not  from oiitomeri or  In  any  way  not  realizable  within  ImmedUt*  future. . . . 

MERCHANDISE.    Finished .ITnflntahed Raw Valued  at  cost  or  market » Is  all  salable  1 „, 

LAND.    Describe  briefly „ Asseaaed  value Market  value 

BnTLDINGS.    Cost! ..Age DeprecUtloa 

MACHINERY  AND  FIXTURES.    Cost  $ Depicclatloo CondlUOtt , 

OTHER  ASSETS. 

Areany  of  aaMtsunaTallable  for  paying  debt*  1 Lmtet 


INSTTRANCE.    StaU  what  kind  and  amount. 


NOTES  PAYABLE.    To  own  banks Throogh  btokers... OtherwiM 

ACCOUNTS  PAYABLE.    Terms  of  purchase ! Do  you  dbconnt  and  anUcIpate f 

DKPOSrrs.    Time  or  demand  ? ;...From  whomt .....1 Interest 

........On  whai  aaseU  a  Uent. 


BONDED  DEBT  AND  MORTGAGES. 
ACCRUED  LIABILITIES.     Itemtee.,.. 


.Rate. 


CAPITAL.    Preferred  Authorlied  $. 

RESERVES.    lUmlze 

NET  SALES. 


.Issued  t Dividends Common  Aathorlted  $ Issued  9 Dividends  t> 


Last  fiscal  year       ...'......«'•••.        .«.. 

Cost  of  sales ■ 

Gross  profit ,'.,..,...... 

fatetest,  taxes,  depreciation,  etc.    ....       

Dividends  paid ■ 

Surplttsfor  year - 

Have  the  looks  been  audited  by  n  CcrUfied  Public  AcconoUnt  I.. .  .If  so,  give  name  of  firm  and  date  of  audit. 

CORPORATE  NAME. , , 

By 

(State  officer's  ti  Jte) 
DitB  signed »•• 

OflksaddreH Natore  of 

of  plant*  and  branch  offlcca < 


CERTIFICATES  AND  REPORTS  381 

have  not  had  the  nerve  to  take  this  advice  except  to  a  hmited 
extent.  There  have,  however,  been  some  "horrible  examples" 
in  which  the  calling  in  of  auditors  previously  to  making  loans 
would  have  saved  the  banks  millions  of  dollars. 

It  will  be  noticed  that  the  bankers  wish  to  read  the  statements 
just  reproduced  along  the  lines  advocated  on  page  367  hereof; 
that  is,  they  want  to  know  about  the  assets  in  the  order  of  their 
availability,  and  want  to  ascertain  the  liabilities  in  the  order  in 
which  they  must  be  discharged. 

An  Excellent  Form. — A  more  recent  form,  prepared  by 
Abraham  E.  Van  Doren,  vice-president  of  the  Irving  National 
Bank  of  New  York,  one  of  the  largest  national  banks  in  the  United 
States,  is  shown  in  detail  on  pages  382  to  385  inclusive.  This 
form  follows  the  rules  laid  down  by  the  Federal  Reserve  Board 
and  is  the  best  one  to  which  the  author's  attention  has  been 
drawn. 

A  desirable  innovation  is  found  in  this  form  in  the  provision 
for  a  notary's  certificate.  Together  with  other  features,  which 
are  designed  to  put  the  borrower  squarely  on  record  as  to  his 
actual  assets  and  liabilities,  this  form  is  expected  to  furnish  legal 
evidence  sufficient  to  convict  the  borrower  of  fraud  if  it  is  shown 
subsequently  that  any  material  discrepancy  exists  between  the 
statement  and  the  facts. 

New  York  Stock  Exchange  Requirements  for  Listing  Securities 

Under  the  heading  of  "Financial  Statements"  the  following 
information  is  required : 

Financial  statements:  (i)  earnings  for  preceding  five  years,  if  available; 
(2)  income  account  of  recent  date  for  at  least  one  year,  if  available;  (3) 
balance  sheet  of  same  date;  (4)  similar  accountings  for  predecessor,  con- 
stituent, subsidiary,  owned  or  controlled  companies;  (5)  corporations 
consolidated  within  one  year  previous  to  date  of  application,  income 
account  and  balance  sheet  of  all  companies  merged  and  balance  sheet  of 
applying  corporation;  (6)  if  in  hands  of  receiver  within  one  year  previous 
to  date  of  application,  (a)  income  account  and  balance  sheet  of  receiver  at 


382 


AUDITING— GENERAL  PRINCIPLES 


CORPORATE  FORM                                                                                                                                                        CREDIT  FILE  H,. 
NAME  (Corpora.  StrU  Undw  Chutw) 
LOCATION 

To  IRVING  NATIONAL  BANK,  New  York 

The  (ollo-inj  tni«  ud  »cc.irat«  lUif mrnt  of  iht  finiiicUI  condition  of  ihit  Corporation  on  the         d>r      of                             »       ■  nude  tad 
fumi.hed  by  the  uiHlersigned  for  the  purpOK  of  procuring  Credit  from  lime  to  lime  with  you  for  our  netoii»ble  piper  or  otherwiw. 

II                  '^JJ"''' 

T...                     1 

QUICK  ASSETS 
Cuh  OD  Hud 

C«h»BMk.(Sch«lulei) 
Note<  Keceivabic  (Schedule  2) 
Account!  Receivable  (Scl»duk  2) 
Invenlory  (Schedule  J) 

INVESTED  AiSSETS 

Und($chc<lulci) 

BuildiB{t(Srl>eduIei) 

Machinery,  Fiaturei,  E<iiupi»M  (leat  RtMnr«» 

Inrennienta  (Schedule  4) 

Patenu  and  Goodwin 

DEFERRED  CHARGES 

Unexpired  Insurance  Premiuma 
Prepaid  Intereit,  etc. 

1 

1 

.Tsa.,.. 

Tora.                  1 

»HORT  TERM  INDEBTEDNESS  (D«.  Witliin  On.  Ycr) 

Nolei  {iven  for  Merrhandite 

Notes  given  for  Borrowed  Money  Itkhedule  1) 

Accounts  Payable  (!>.hedule») 

Liability  for  Acceptances  under  Ulterj  of  Credit  (Schedule  1> 

Deposits  of  Monty  (Schedule  i) 

Dividends  Unpaid,  Accrued  and  other  Liabilitiea 

LONG  TERM  INDEBTEDNESS  (D>i.  Afl.rODaYtw) 

Notes  given  for  Borrowed  Money  (Sehtdul*  1) 

Deposits  of  Money  (Schedule  S) 

Bonded  Dept.  (Schedule  7) 

Mortgages  on  Real  Estne  or  Chattels  (Schedule  t) 

Other  Liabilities  due  after  one  year 

TOTAL  UAHUTIU 

CAPITAL 

Preferred  Stock  Issued 
Common  Slock  luued 
Surplus  (As  per  Surplus  Account) 
Deficit  (As  Per  Surplus  Account) 

Amount  of  Forward  Purchases  not  included  in  either  AsseU  or  Labilities 

rwM  sicNATvae 
Ue  l>.|»                                                                                                                    n 

CERTIFICATES  AND  REPORTS 


383 


CONTINGENT  LUBIUTY        (F«J.r.l  R«.«rT.  Buk  Reqair«m.>t) 

a«.UHT 

f  OR  M 

AMOUNT           1 

Upon  Customer.  Notes 

Discounted,  Sold,  or  Othen»i«  Tnnrferred 

Upon  Drafts  Discounted  or  Sold 

Upon  Bond.  oroth^Oblipt^on.^,^^^ 

Upon  Lmsm 

For  Accommodation  Endorsements  or  Guarantee. 

Under  Condi.ional  Sale  Contract. 

or  Purchase  Arrangement. 

Under  Agreement  for  Stock  or  other  Subscription 

Under  Pending  Urn  Suit. 

a                                                      TOTAL 

I.  this  Company  a  guaruitor  or  endorser  of  any  Uabilities  of  any  individual,  firm,  or  corporation,  or  is  it  liable  under  any  contneu  bond)  or  pro6t 
sharing  arrangements  or  any  other  aggreement.,  or  are  there  any  la«-suiu  pending  except  as  set  forth  above? 

PROFIT  AND  LOSS  ACCOUNT  FROM                                        1»        to                                        19 

Inventory  at  beginning  of  Period  (                19     ) 

Purchases-Net  (Lei.  Returns,  etc.,  t                  ) 

Operaung  Expenaet 

General  Expenses 

Bid  Debts  Charged  Off 

DeprecUtion  Charged  OH 

Reserves  Created 

Mrr  raoriT 

TOTAL 

Inventory  at  End  of  Period  (                          19     ) 

Sales-Net  (Les.  Return.,  etc.,  t                           ) 

Commiuion.  Earned 

Discount.  Earned 

Income  from  Invertment.,  etc. 

TOTAL 

SURPLUS  ACCOUNT  FISCAL  PERIOD  ENDING                                                                    >» 

Deficit  at  beginning  of  Period 
Dividends  Paid  Pref.  t                  Com.  t 
Special  Reserves  Created 
Other  Charges  to  Surplus 

Net.  Los.    (fromPiLAcct., 
Surplus  a.  per  sutemeM 

TOTAL 

Surplu.  at  beginning  of  Period 
Credits  to  Surplus  during  Period 

Net  Profit  (from  P&LAcct.) 
Oeficil  a.  per  Strtement 

TOTAL 

INSURANCE 

FOKM 

ASSETS  COVERED 

•ENEFiciaar 

ASSICNU 

—                   1 

Fire 

Fire 

Credit 

Life 

Other  Kind. 

Merchandise 

Buildings  and  Equipment 
Account,  and  Bills  Receivable 
Endorsers  or  Execuuvet 

TOTAL 

SCHED.  1  CASH.  NOTES  GIVEN  FOR  BORROWED  MONEY,  AND  LIABILITY  FOR  ACCEPTANCES  UNDER  LETTERS  OF  CREOIT 

DEPOUTORY  lANKS 

C»bB^>.o,>. 

L.«rfC,rti.R^ 

omm  M>t»ci>  or  oioir 
(Note  Broker) 

TotJ  a.  per  Balance  Sheet 

11  your  Btanche.  borrow  locally,  sute  amount  owmg  not  Ucluded  in  biUs  payable  (Schedule  1)»                                                                                                  1 

384 


AUDITING— GENERAL  PRINCIPLES 


SCHEDULE  2     NOTES  AND  ACCOUNTS  RECEIVABLE 


For  Mtrchandise  Sold  upon  Regular  Terms 

Accounts  Receivable  over  SU  Month>X)lil  or  Past  Due  Noies 


DUE  FROM  OTHER  DEBTORS,  (Intor-Company, 

Officers,  Directors,  Slockhotders  or  Employees 

Ovrn  Selling  Houses  or  Branches 

Subsidiary  Corporations 

Allied,  Controlled  or  Afliliated  Interests 

For  Capital  Slock  Sold 

For  Merchandise  on  Consignment 

Cash  Advances  (Security  Therefor  if  Any  $ 

Commissions  Due  and  Payable 

Other  Accounts  and  Notes  Receivable 

Less  Reserves  Created  to  Cover  Possible  Discount  and  Losses 


Cootrollcd  CompAniet.  etc) 


TOTAL  OTHER  DCBTOKS 


TOTAL  »S  PER  BALANCE  SHEET 


What  Amount  of  Accounts  or  Notes  receivable  has  been  Discounted  or  Pledged  > 


SCHEDULE  3.  INVENTORY  (Should  be  taken  .t  cost  or  market  price  -  whichever  i.  lower) 
12 Bx 


Finished  Merchandise 

(How  Priced* 

) 

Merchandise  in  process 
Raw  Material 

(  "        " 
(  "        " 

) 
) 

Other  Itema  Included  in  Inventory 

Less  Reserve  and  Allowance  for  Merchandise  of  Obsolete  Pattern  or  Otherwise  not  Readily  Saleable 

What  Amount  is  held  by  you  under  Trust  Receipt  I 

What  Amount  do  you  hold  on  Consignment  (Included  in  Inventory^ ) 

What  Amount  has  been  Pledged  as  Collateral  for  Loans  or  Advances? 

What  Amount  has  been  priced  at  more  than  Cost? 

What  ii  Amount  of  Unfilled  Orders  on  Hand? 

SrHFnillF  4.  INVFSTMFNT'; 


TOTAL  AS  PE»  I 


DESCKirXION  OP  SECUMTY 


AllOtJNT  PLEDGED 


BOOK  VUMt 


TtiTti,  ii  PF»  iiti  tNr»  wrrr 


SCHEDULE  5     DEPOSITS  OF  MONEY 


NAME  OP  DEPOSITOR 


Ttn-AL  AS  PER  BALANCE  SHEET 


CERTIFICATES  AND  REPORTS 


385 


SCHEDULE  •    .  ACCOUNTS  PAYABLE 


For  MclchudiBC  Purchued  upon  Regular  Termi,  Not  Due 
.,  ,.  ..  „  ..  .<      pa„Du« 

Due  OflScen,  DIreclori,  StockhoUeri  or  Employeei 
Other  Accounts  Payahlc 


Schedule  7  ■  66nd£o  dEbt  (F«l.r.iR...r;.B»d<R«iuir»»':o^ 


•nVtm  0%  MOKTCACI 


'hat  Asset!  are  t!i< 
for  Retiremeiit 


SCHtDULE  8  -  REAL  ESTATE        (Pleaio  fir*  particuUra  of  Mchpwcel) 


L  OC  A  T I  O  > 


owNEa  or  aicoao 


TOTAt  AS  Pn  (ALAKCt  SHCIT 


VERIFICATION 

and  date  of  Audit 

CHARACTER  OF  BUSINESS    (P«I«aJ 

Describe  briefly  the  chaiacter  of  Busineu  you  conduct 


PURPOSE  OF  BORROWING 


If  your  books  hare  been  audited  by  a  Certified  Public 


{ftdml  Rmctt*  Buk  R«|uir«B«sl) 

State  whether  the  proceeds  of  Loans  applied  for  or  to  be  applied  for  are  to  be  used 

(A)  For  Investment  in  Securities,  Lands,  Plants,  Building,  Machinery,  Impfovements  or  Equipment, 

(B)  In  the  Production,  Manufacture  and  Distribution  of  Commodities  of  A^culture,  Industry  i 
MAXIMUM  AND  MINIMUM  LUBIUTIES 

Vfheu  did  your  Liabililiet  reach  their  Maximum  last  year  19      .    Amount  $ 

Ha»e  any  of  your  Accounts  bees- Assigned  or  Auets  Pledged  or  is  thcreany  Lien  upon  them  except  aa  noted  above  t 


I  la  osoat  auanlial  that  Mch  quest  i< 
AFFIDAVIT 

STATE  OF  J    ^ 

COUNTY  OF  /'■*' 

the  Corporation  whose  ftnar 


-being  duly  sworn  depowi  and  nyt;  tUt 


VOL.  I — 25 


386  AUDITING— GENERAL  PRINCIPLES 

time  of  discharge,  and  (b)  balance  sheet  of  company  at  close  of  receiver- 
ship. 

and    under    ''Agreements"    appear    the    following    additional 
requirements : 

To  publish  at  least  once  in  each  year  and  submi4:  to  the  stockholders,  at 
least  fifteen  days  in  advance  of  the  annual  meeting  of  the  corporation,  a 
statement  of  its  physical  and  financial  condition,  an  income  account  cover- 
ing the  previous  fiscal  year,  and  a  balance  sheet  showing  assets  and  liabili- 
ties at  the  end  of  the  year;  also  annually  an  income  account  and  balance 
sheet  of  all  constituent,  subsidiary,  owned  or  controlled  companies;  or  a 
consolidated  income  account  and  a  consolidated  balance  sheet. 

Federal  Reserve  Board  Requirements 

The  Federal  Reserve  Board,  whose  regulations  should  in  time 
become  the  controlling  authority  with  respect  to  financial  state- 
ments, has  issued  model  forms.  These  are  for  corporations, 
partnerships  or  individual  owners,  and  individuals,  respectively. 
The  forms  (revised  in  July,  192 1,  by  the  Federal  Reserve  Bank 
of  Richmond)  are  reproduced  on  pages  387  to  392. 

These  forms  will  repay  careful  study.  Notice  especially  the 
manner  in  which  the  segregation  of  current  assets  from  other 
assets  is  made;  also  the  manner  of  arrangement  of  the  liability 
side  of  the  balance  sheet.  Note  also  the  segregation  of  notes  re- 
ceivable, acceptances,  and  accounts  receivable  into  two  classes, 
namely:  those  ''not  yet  due"  and  those  "past  due,"  as  well  as 
the  method  of  deducting  reserves  for  those  that  are  doubtful  or 
bad.  The  method  of  stating  the  surplus  of  corporations  and  the 
net  worth  of  partnerships  is  such  that  the  important  factors 
affecting  those  accounts  are  clearly  set  forth,.  On  the  reverse 
side  of  the  statements  are  detailed  questionnaires.  Space  is 
given  on  each  form  to  the  important  matter  of  contingent  lia- 
bilities. In  arriving  at  net  income  for  the  period,  depreciation  is 
deducted  as  an  expense.  Stocks  are  not  included  in  current  as- 
sets, yet  if  marketable  they  are  more  current  than  is  the  inven- 
tory of  merchandise.    The  prepaid  items  which  belong  in  current 


rwoatAL  MCSERVC  BANK  OT  MCHMONO 


FORMCR9 

RNANCIAL  STATEMENT 
OF 
MANUFACTURING  OR  MERCANTILE 


CORPORATION 
CMTE  OF  STATEMENT 

19. 


Vjmb  of  Cobpobatioi»_ 
Location  or  Bcstness.. 
Charactek 


ASSETS                                                   II 

LIABILITIES 

1.    C«ih-On  H»nd  a»d  in  Bank 

$ 

18. 

Notes  Payable:                                                             { 

2.    Notes    ReceivaUe    and    Acceptances— Doe    from 

(b)    To  Banks  for  Money  Borrowed 

"" 

(a)  Not  yet  Due 

(c)    Others 

Accounts  Payable: 

2a 

21. 

22. 
23. 
24. 

25. 
26. 

27. 

28. 

29. 

30. 
31. 
32^ 

3J. 

34. 
35. 
36. 

Z.    Accounts  Receivable-Due  from  Oatoaen  ((or 
goods  sold  to  them): 
(a)  Not  yet  Due 

Acceptances: 

<h)  P«t  n...                           »            , 



...  .. 

Less  Seaerre  foe  Bwl  and 

HonKi^nl                           f 

Accounts  and  Notes  Due  to  Officen,  Stockholders 



4.    Due  for  Merchandise  Sold  or  PUeed  on  Consign- 
ment 

Deposits  of  Money  with  Us 

(7,—,,,,^  y^„,  f           ,     .. ) 

6.    IsTentory-Meichandife; 

(r)  Raw  Material             t    .       ,.. 

Liability  for  Notes  and  Aceounts  (shown  in  Assets) 
which   have   been  Sold,   Assigned,   Fledged  or 
Discounted 

Reserve  for  Federal  Taxes 

Accrued  Expenses-Other  Taxes,  Interest,  Salaries, 

6.    Liberty  Bonds  and  V.  S.  Certificates  of  In<Mrt«i- 

Dividends    Unpaid-Including    CmnoUtive    and 

7.    Other  Quick  Assets  (Itemise): 

Other  CuiWnt  LiabUities  (Itemise) : 

. 

. 

TOTAL  CURRENT  LIABIUTIES 

Mortgages     on     Plant    or    Real    Estate 

(when  due _ ) _ 



z 

(ttmmt  MukM  PriM  »_ ) 

— 

Chattel  Mortgages .-: 

(It«nl«e): 



10.    Accounts   and   Notes  due  from  Officen,   Stock- 
holdere  and  Employees 

11.    Land  and  Buildings  (used  for  Plant) 

12.    Other  Real  EsUte 





Other  LiabiUties  (Itemise) : 

14.    Furniture  and  Fixtures 

15.  Patents,  Trade  Marks,  Royalties,  Lewes,  Good 

16.  Deferred  Charges: 





TOTAL 

Capital  Stock  Outstanding-Common 

~ 

Surplus  and  Undivided   ProfiU    (per  sUtement 
telow) 

(Pr»«.l  M«krt  ViJ».  olAIl"0«l»»A»to."  t ) 

TOTAL 

S 

TOTAL                                                         \i              1 



CONDENSED   PROFIT  AND   LOSS  ACCOUNT   FOR   PERIOD   FFKJM  . 


^ 

Sales-Net  (less  Returns,  Allowances,  etc) 

Add  Purchases-Net  (less  Returns,  Allowances,  etc).. . 

TpTAL 

Interest  Earned 

Less  Inventory  at  End  of  Period 

COST  OF  GOODS  SOLD 

" 

Losses  of  Previous  Periods  Recovered 

Income  from  Other  Sources  (Itemise) : 

%\^i^)"^  ^^'  ^^"^  ancluding  Dfaeount. 

Ceneral  Expenses  (Including Interest).. .;.. 



Bad  Debts  Charged  off 

Depreciation  Charged  off....." ,.... 

N«t  Uu  for  Period , 

1 

Reserved  for  Federal  Taxes  tfor  Current  Jteiod) 

1 

! 

TOTAL...-. 

I              1 

TOTAL 

i               1 

SURPLUS  AND  UNDIVIDED  PROFITS— FOR  ABOVE  PERIOD 




Dividends  Dei-luorf— Cnminnn 

. 

1 

fipecisl  Reserves  Creited  out  of  Sarjdos 

. 

_..„ 

"' 

Net  Profit  for  Period  (from  Profit  and  Lea  Aecooot 
above) ,,„,.„ •. 

Nrt^o-  for  Period  (from  Profit  and  Loss  Aceeont 

■ 

8iil]ifa>«i>d  Undivided  Profits  at  End  of  Period 

* 

It 

1 

387 


C0^4TINGENT  LIABILITIES  AT  DATE  OF  THIS  STATEMENT 


Customers'  Notes  «nd  Acceptances  Discounted,  Sold,  Assigned  or  Pledged ' , 

|( 

==~ 

— 

Customers' AccounU  Sold,  Assigned  or  Pledged,.; '. ...; 

,.. 

• 

Lisbility  u  Endorser  or  Guarantor  for  Others  on  Notes,  Contracts  or  Other  Obligations 

•• -— ;• 



Liability  upon  Notes,  Bonds,  Cootr'acts  or  Other  ObligaUons  of  Subsidiary  Companies 

Liability  for  Uases .'. 

' 

TOTAL ;..... J. 

t. 

"~~ 

Has  this  Corporation  any  Contingent  Liability  of  any  description  except  as  set  forth  above? 

If  so.  describe __ „ _ _ and  slate  amount  t _ _ 

NOTE.-IT  IS  NECESSARY  THAT  ALL  OF  THE  FOLLOWING  QUESTIONS  RELATING  TO  THE  STATEMENT  BE  ANSWERED  CAREFULLY 
I.    (»)    Are  any  Notes,  Acceptances  or  Accounts  Receivable,  which  have  been  discounted,  sold,  assigned  or  pledged,  shown  among  your  Assets?. . 


(b    If  so,  is  the  amount  of  money  or  advances  received  by  you  against  them  shown  in  Liabilities  (Item  24)?.... (c)    1/  none  of  suck. 

Notes,  Acceptances  or  Accounts  Receivable  are  shows  among  Assets,  are  they  shown  above  in  Contingent  Liabilities?...— __„. 

3.  (a)    Upon  what  terms  do  you  sell? d«y».    (b)    Do  any  of  your  Accounts  Receivable— "Not  Yet  Due"  (Item  3-a)  extend  over  a  longer 

period? (e)    What  amount?  t (d)    What  is  the  average  age  of  your  Accounts  Receivable— "Past  Du»"  (Item  5-b)f 

months,    (e)    What  amount  do  you  consider  good?  1 

X    (a)    Is  the  amount  of  your  Consignment  Accounts  or  Merchandise  on  Consignment  (Item  4)  shown  at  your  Inventory  Value  or  your  Selling  TriceT 
, (b)    If  at  your  selling  price,  what  is  the  cost  or  Inventory  Value?  1 

4.  (a)    When  was  the  Merchandise  Inventory  (Items  S-a,  -b,  and  -c)  taken?._.. (b)    Was  it  valued  at  <5oef  to  you  or 

Market   Price  (replacement  value)  at  date  of  Inventory? . (c)    Which  was  lower.  Cost  or  Market?. .,. ■      , 

<d)    What  do  you  estimate  to  be  the  price  of  replacement  (nurket  cost  to  you)  of  your  entire  Inventory  at  date  of  this  statement?  t 

(e)    Was  the  total  amount  of  Inventory  (as  shown  in  Assets)  actually  owned  by  you ;  that  is,  either  paid  for  or  the  liability  (or  it  set  up  in  Current  Lis* 
bilities?    ■    ,      ,  (f)    Amount  of  Insurance  carried  on  Inventory?  1 

5.  (a)    What  is  the  present  market  value  of  Slocks,  Bonds  and  Other  Investments  (Item  8)?  t (b)    Are  any  of  such  Investments  repre« 

sented  by  obligations  of  Subsidiary,  Controlled  or  Allied  Concerns? (c)    What  amount?  t 

«.    (a)    How  much  of  tie  amount  duo  from  Subsidiary,  Controlled  or  Allied  Concerns  (Item  9)  was  for  merchandise?  $ (b)    How  much 

for  advances,  loans  or  deposits?  t^ (c)    Give  names  of  such  concerns 


7.-  (a)    How  did  the  Accounts  and  Notes  due  by  Officers,  Stockholders  and  Employees  (lum  10)  arise?- 
(b)    Axe  any  of  them  past  due? —    (c)    How  old  are  they? 


I.    (a)    WhatistheAssessedValueofLahdandBuildings-Usedfor  Plant  (Itemn)7$. (b)  Of  Other  Real  EsUte  (Item  12)?$ _ 

(c)    Has  a  fair  and  reasonable  amount  been  charged  ofT  for  depreciation  on  Machinery  and  Equipment  (Item  13)  and  Furniture  and  Fixtures  (Item  14)  ^ 

, {d>    Amount  of  Insurance  carried  on  Plant  Buildings?  $.„..., .    (e)    On  Other  Real  Estate?  t 

(f)    On  Machinery  »nd  Equipment?  $ (g>    On  Furniture  and  Fixtures?  |.^. 

9.    (a)    Name  Banks  from  which  you  are  borrowing  ami  amount  borrowed  from  each  (Item  I8-b) ' 


(b)    Amount  of  your  Notes  Payable  secured  by  Collateral?  $ (c)    Describe  Collateral  giving  amount  of  each  1 

(a>    Ate  all  Notes  Md  Accounts  Payable  for  Merchandise  Purchased  (Items  18-s  and  19-a)  shown  in  Liabilities,  whether  or  not  goods  have  been  reoeivedf 
.  (b)    What  amount  is  not  shown?  1 .    (c)    Notes  and  AccounU  Payable— Others  (Items  18-c  and  19-b)  repre- 


•ent  whatT  ,,  ■  (d)    Are  any  Notes  or  Accounts  Payable  past  due7_. 

(e)    If  so,  what  amount?  $ . 

It.    (a>   If  no  provision  has  been  made  for  Federal  Taxes  Otem  25),  state  estimated  amount  $ 


17.    (a)    On  what  Assets  is  your  Bonded  Debt  (Item  30)  a  lien?. „ ,.  (b)    Sate  of  Interest ?- 


(c)    Is  the  amount  of  Accrued  Interest  on  Mortgages  and  Bonded  Debt  included  in  Item  26?. <d)    If  not,  where?_ 

(e)    What  provision  is  made  for  retirement  of  Mortgages  (Item  29)  and  Bonded  Debt  (Item  SO)? 


(Location) 

The  foregoing  financial  sUfement  and  other  representotions  are  made  by  the  undersigned  corporation  for  the  purpose  of  procuring  credit,  obtaining  loan* 
end  discounting  papei  with  you  from  time  to  time.  If  any  unfavorable  change  In  our  financial  condition  occurs,  the  undersigned  agrees  to  immediately  notify 
you,  and,  in  the  absence  of  such  notice,  you  may  continue  to  rely  upon  this  statement  as  being  substantially  true  and  accurate  and  continuing  in  force  and  effect. 

The  foregoing  financial  statement  and  all  details  pertaining  thereto  have  been  carefully  gone  over  by  the  undersigned,  and,  as  an  officer  of  the  corporation 
duly  Autborizea  to  contract  liabilities,  I  hereby  solemnly  declare  and  certify  that  they  set  forth  a  true  and  accurate  statement  of  our  financial  condition. 


Name  of  Corporation- 


(Suteroents  submitted  to  the  Federal  Reserve  Bank  of  Richmond  must  be  signed  originala'Or  certified  copies.    If  copies  are  submitted,  the  following 
certificate  must  be  officially  signed  by  member  bank. )  ^^^^^^ 


Name  of  Member  Bank_. 


OfllcW  SiSMturet- 

388 


FEOERAl.  RESERVE  BANK  OF  RICHMOND 


FORM  CR  10 

FINANCIAL  STATEMENT 

OF 

MANUFACTURING  OR  MERCANTILE  BUSrNESS 


TO  BE  USED  BV 
FIRM  PABTNERSHII* 
INDIVIDUAL  OWNEK 


Kami:  or  Fnui  or  InoividtjaIi. 

Location  of  Business.™ 

Charactek  of  Bosiness — 


ASSETS                                                      II                                                  LIABILITIES 

1     Cub— Od  Hand  and  in  Bank 

f 

18.    Notes  Payable: 

' 

2.    Not«.    Receivable    and    Acceptances-Due    from 

Cuatomer.  (not  diacountei  or  toU) : 

(b)  Pa.tl>«e    1 ...._ 

19.    Accounts  Payable:' 

(a)    For  Merchaniliaa  PuretftMd 

good. «old  to  them): 

20.    Acceptances: 

(b)  Past  Due t 

Leas  Reserve  for  Bad  and 

(b)    Banker.'  Acceptaoce»-For  our  (my)  Ac- 

21.    AceounU  and  Note*  Due  to  Partner*  and  Em- 
ployee* 

4.    Due  for  Merchandise  Sold  or  Placed  on  Conaign- 

22.  Deposits  of  Money  with  this  Firm  or  Individual . . . 

23.  Due  to  Subsidiary,  Controlled  or  Allied  Concerns. . 

24.  Liability  for  Notes  and  Accounts  (shown  in  AaaeU) 

which   have   been   Sold,   Assigned,   Pledged  or 
Discounted                                                  

S.    Inventory— Merchandise: 

(b)  InProceasof  Manufacture  S 

26.    Accrued  Expenses— Other  Taxes,  Interest,  Salarie*, 

(PnMiit  IbrkM  Price  «           ) 

7.    Other  Quick  AsseU  (lUmise) : 

27.    Other  Current  Uabilitie*  (ltemi«i) : 

(PnMatll<tk>CVi>h»./AnOtb«QiuckA>M>.> ) 

TOTAL  CURRENT  ASSETS 



TOTAL  CURRENT  LIA9IUTIES 

28.    Mortgages  or  Liens  on  Plant  or  other  Real  Estate 
(when  due .,, ^ ) 

29     Chattel  Mortgage*     ...v 

8.    Stocks.  Bonds  and  Other  Investments 

«.    Due  from  Subsidiary,  Controlled  or  Allied  Con- 

10.    AccoOnU  and  Notes  due  from  partners  and  Em- 

30.    Reserves— Depreciation      9r      OtM$>     H«*enr«* 

— 

13.    Machinery  and  Equipment 





~. 

3L    Other Litbilitie*  (Itemise): 

W.    Drferred  Charges: 

TOTAL  

(b)    Prepaid  Interest                

17.    Other  As«!U{IUmise): 

TOTAL 

t 

„ 

TOTAL 

1 

,.._ 

=» 

CONDENSED   PROFIT   AND   LOSS   ACCOUNT   Ft3R   PERIOD   FROM 


f 

'"    e  1  ^v  .  /I  -.p  .    „."Vi"il.r..lJ  -..^ 





..__.. 

Less  Inventory  at  End  of  Period. . ; ....'....: 

Income  from  Investments 

Losses  of  Previous  Periods  Recovered.. :.:;.: rr.... V.>. : 
Income  from  Other  Source*  (Itemin) :                          ^ 

~^~' 

-_ 

Operating  and  Selling  Expenses  (Including  DiscounU 
Allowed) 

■ 

Bad  DebU  Charged  off 



Reserved  for  Federal  Taxes  (for  Current  Period). . : .'. . . 

Net  Profit  for  Period 

TOTAL 

$ 

% 





STATEMENT  OF  NET  WORTH— FOR  ABOVE  PERIOD 

Withdrawals  by  Partners  or  Individual  Owner   (other 
than  Salaries,  which  should  be  included  in  Expenses 

Net  Worth  at  Beginning  of  Period 

Special  Deposiu  or  locreaae*  in  Net  Worth  not  Earned 

i 



Special  Withdrawals  or  Reserve*  created  out  of  Net 

Net  Profit  tor  Period  (from  Pro6t  ami  Lot*  Account 
abov*)      •     .  •"■ 

Ket  Los*  for  Period  (from  Profit  and  LoM  Account 





TOTAt 

Net  Worth  at  End  of  Period 

TOTAL 

»       .     . 

,_ 

389 


CONTINGENT  LfABILITIES  AT  DATE  OF  THIS  STATEMENT 


OMtomera'  Notes  and  Accept»nce«  Discounted,  Sold,  Aligned  or  Pledged 

Oiutorners'  Accounts  Sold,  Assigned  or  Pledged 

Liabilit)'  under  Purchase  Contracts  or  AgreUmenU  as  to  Purchajes  (of  whatever  character).. 

Liability  for  Bonds  or  Unfinished  Sale  Contracta 

Liabilit J  as  Endorser  or  Guarantor  for  Others  on  Notes,  Contracts  or  Other  Obligatioiu 

ioability  upon  Notes,  Bonds,  Contracts  or  Other  Obligations  of  Subsidiary  Companies 

Iritbility  for  Leases : 


i±: 


Have  you  any  Contingent  Liability  of  any  description  except  as  set  forth  above?  . 

If  so,  describe „ - — 


NOTE.— it' IS  NECESSARY  THAT  ALL  OF  THE  FOLLOWING  QUESTIONS  RELATING  TO  THE  STATE.MENT  BE  ANSWERED  CAREFULLY 

(a)    Arc  an^ 'Notes,  Acceptances  or  Accounts  Receivable,  which  have  been  discounted,  sold,  assigned  or  pledged,  shown  among  your  Assets?. 

(b    If  so,  is  the  amount  of  money  or  advances  received  by  you  against  them  shown  in  Liabilities  (Item  24)? (c)    U  noneof  si^fw^ 

Notes,  Acceptances  or  Accounts  Receivable  are  shown  among  Assets,  are  they  shown  above  in  Contingent  Liabilities?. 

(a)'  Upon  what  terms  do  you  sell? days,     (b)    Do  any  of  your  AccounU  Receivable— "Not  Yet  Due"  (Item  3-a)  extend  over  a  longer 

IMriod? (c)    What  amount?  t - (d)    What  ia  the  average  age  of  your  Accounts  Receivable— "Past  Due"  (Item3-b)7 

months,     (e)    What  amount  do  you  consider  good?  S ^-.-. 

(k)    II  the  amount  of  your  Consignment  AccounU  or  Merchandise  on  Consignment  (Item  4)  shown  at  your  Inventory  Value  or  your  Selling  PriceT 

,...    (b)    If  at  your  selling  price,  what  is  the  cost  or  Inventory  Value?  t. 

(a)    When  was  the  Merchandise  Inventory .  (Items  5-a,  -b,  and  -c)  Uken? (b)    Was  it  valued  at  Coet  to  you  or 

Market   Price  (replacement  value)  at  date  of  Inventory? - _.._ (c)    Which  was  lower,  Coet  or  Market? 


(d)  What  do  you  estimate  to  be  the  price  of  replacement  (market  cost  to  you)  of  ycir  entire  Inventory  at  date  of  this  statement?  t . 

(e)  Was  the  total  amount  of  Inventory  (as  shown  in  Assets)  actually  owned  by  you ;  that  is,  either  paid  for  or  the  liability  for  it  set  up  in  Current  l4»» 
bilities? (I)    Amount  of  Insurance  carried  on  Inventory?  t -.... 

(a)    What  is  the  present  market  value  of  Stocks,  Bonds  and  Other  Investments  (Item  8)7  i 

aented  by  obligations  of  Subsidiary,  Controlled  or  Allied  Concerns? 

(a)    Bow  much  of  the  amount  due  from  Subsidiary,  Controlled  or  Allied  Concerns  (Item  9)  wss  for  merchandise?  <,,.,„ -,.,r:^ (b)    How  much 

for  advances,  loans  or  deposiu?  ( (c)    Give  names  of  such  ( 


7.    (a)  •  How  did  the  Accou«te  and  Hoift  do*  by  Fkrtnen  and  Employees  (Item  10)  arise? . 
(b)    Are  any  of  them  pa«t  due? fc)    How  old  are  they?. , 


S.     (a)    What  is  the  Assessed  Value  of  Land  and  Buildings— Used  for  Plant  (Item  II)?  t (b)  Of  Other  Real  Estate  (Item  12)?  »_ 


(c)  Has  a  fair  and  reasonable  amount  been  charged  off  for  depreciation  on  Machinery  and  Equipment  (Item  13)  and  Furniture  and  Fixtures  (Item  U)? 

,  (d)    Amount  of  Insurance  carried  on  Plant  Buildings?  $._ ^.     (e)    On  Other  Real  Estate?  T 

<f)  On  Machinery  and  Equipment?  t (g)    On  .Furniture  and  Fixtures?  t 

%    (»)  Name  Banks  from  which  you  are  borrowing  and  amount  borrowed  from  each  (Item  18-b) , 


(b)    Amount  of  your  Notes  Payable  secured  by  Collateral?! (c)    Describe  Collateral  giving  i 


It.    (a)    Are  all  Notes  and  Accounts  Payable  for  Merchandise  Purchased  (Items  18-a  and  19-a)  shown  in  Liabilities,  whether  or  not  goods  have  been  received? 

(b)    What  amount  is  not  shown?  » (c)    Notes  and  AccounU  Payable— Others  (Items  ISh:  and  19-b)  repre- 

(ent  what? (d)    Are  any  Noteii  or  AccounU  Payable  post  due? ,. 

(e)    If  so,  wh»t  amoiit?  $. 

It,     (a)    If  nt>  provision  has  been  made  for  Federal  Taxes  (Item  2&),  state  estimated  amount  t 

12.     (a)    Is  there  any  Mortgage,  lien  or  Bonded  Debt  against  any  of  your  AsseU,  except  as  shown  in.  Items  28  and  ^?  , 

(b)  If  so,  describe. ... 

(c)  Where  is  the  Liability  shown  in  the  Statement? (d)    What  is  the  Rate  of  Interest  on  Mortgages 

(Item  28)? (e)    Is  the  amount  of  Accrued  Interest  on  Mortgages  included  in  Item  26? , (f)    If  not,  where? 

(g)    What  provision  (if  any)  is  being  made  for  the  retirement  of  Mortgages?- 


(Location) 

The  foregoing  financial  statement  and  other  representations  are  made  by  the  undersigned  for  the  puipose  of  procuring  credit,  obtaining  loans  .ind 
discounting  paper  with  you  from  time  to  time.  If  any  unfavorable  change  in  our(my)  financial  condition  occurs,  the  undersigned  agrees  to  immediatelv  notify 
you,  and,  in  the  absence  of  such  notice,  you  may  continue  to  rely  upon  this  statement  as  being  substantially  true  and  accurate  and  continuing  in  force  and  ciTeci. 

The  foregoing  financial  statement  and  all  details  pertaining  thereto  have  been  carefully  gone  over  by  the  undersigned,  and  1  hereby  solemnly  declare  and 
tertify  that  they  set  forth  a  true  and  accurate  sutement  of  our  (my)  financial  condition. 


Name  of  Firm  or  Individual. 


(Member  of  Firm  or  Owner) 


;  of  Richmond  must  be  signed  originals  or  certified  copies.    If  copies  are  submitted,  *Le  following 


We  hereby  certify  that  the  forefoing  Is  ■  Uii«  and  correct  copy  of  a  signed  financial  statement  of  the  abovo  mentioned  firm  or  Indhridual  now 
«DtU«latiiUt>»i>k 

Htm*  of  Member  "'"'■ 


Official  SignaturCL. 


naaUkL  MSIRve  bank  of  Richmond 


FORM  CR  II 


FINANCrAL  STATEMENT 

OF 

FARMER  OR  OTHER  INDIVIDUAL 


DATE  OF  STATEMENT 


NAim 

Address.-. 
Business.. 


ASSETS                                              II                                             LIABILITIES 

t 





3.  Loan.  Due  Me-Un«cured-Good 

4.  Loans  Due  Me-Secured-(except  Mortgage  Loan. 

23.    Notes  Owed  by  Me— With  Security  other  than 

■ee  Item  10  below)— Due  within  Six  Month* 

Real  Estate  or  Chattel  Mortgages 

24.  Mortgages  Owed  by  Me-On  Farm  Property 

25.  Mortgages  Owed  by  Me-On  Town  or  City  Real 

Estate 

— 

--- : 

— 

8.    Other  Merchandiae  on  Hand  (or  Sal*  atemiie) : 

-- 

(Ditii  Diiit                                          ) 

26.    Notes  Owed  by  Me  with  Chattel  Mortgages  as 
Security 

«.    Liberty  Bonda  and  Other  United  States  Securities . 

27.    U.  8.  Government  Tuces-Unpaid 

•••-"•■• 

•— 

28.    State  County  or  Other  Taxes— Unpaid 

Months  (Me  Item  4'sbove) 

29.    Any  Other  Indebtedness  (Itemise) : 

12.    Live  Stock  on  Hand-For  Own  Use  (see.  Item  7 
aboT») 

13.  Farm  Land-Cultivated  ( __acres) 

14.  Farm  Land-Not  Cultivated  ( _ ....acres) . . 



— 

17.    Buildings  and  Other  Improvements  Thereon 

19.    Investment*  in  Stock*  and  Bond*    (at  Present 

Market) 

9tk    Any  Other  Property  or  Investments  (Itemise): 



TOTAL  LIABILITIES 

1 .„ 

TOTAL 

1 

TOTAL 

» 

CONTINGENT  LIABILITIES  AT  DATE  OF  THIS  STATEMENT 

Liability  as  Endorser  on  Notes  of  Other  Persons  Firms  and  Corporations                     '                 

$ 

.. 

Liability  as  Guarantor  for  Accounts  or  Notes  of  Other  Persons,  Firms  or  Corporations          '. ; 

' 

Liability  on  Notes  Exchanged  with  Others 

Liability  for  Leases „ • 

. 

LiabiUty  for  Judgmenu  or  SuiUPendim  against  Me 

TOTAL 

I.... 

"■"• 

Baveyou  any  Contingent  LiabUity  of  any  demsriptioo  except  ■■  sat  forth  aboveT- 
If  so,  describe 


.jind  state  amount  $.. 


391 


392  AUDITING— GENERAL  PRINCIPLES 

NOTE-IMPOPTANT-PLEASE  ANSWER  CAREFULLY  AND  FULLY  THE  FOLLOWINQ  QUESTIONS: 

I.    (»)    Are  you  *  Partner  in  »ny  Virt,'* 


(b)    Ii  there  aoy  person  interested  in  your  busin 


3.    (>)    Are  any  of  the  Accounts  and  Loans  due  you  (Items  2,  3,  4  and  10)  past  due?- 
A)    Jf  so,  describe  and  give  amounts 


J.    (a)    Are  your  Inventories  of  Farm  Products,  lire  Stock  and  other  Merchandise  (Items  b,  6,  7  and  8)  valued  at  present  Market  PrieaT- 
(b)    If  not.  how  valued?. : -. 


(e)    What  do  you  estimate  you  would  have  to  pay  for  the  same  today,  namely :  Farm  Products  (Items  5  and  6)7 1 live  I 

(It«m7)rS , , Other  Merchandise  (Item  8)?  I 

(d)    What  Iiwuranee  do  you  carry  on  Farm  Products  (Items  i  and  6)7  t. .    On  Live  Stock  (Item  7)?  «  On  i 

Merchandise  (Ifec:  8)7  $. 


4.    (a)   What  amount  of  Mortgage  Loans  due  you  (Item  10)  will  fall  due  within  six  months?  I.- 


f.    (a)    Is  your  Farm  Property  (Items  13,  14  and  IS)  in  your  own  name?- 
(b)    If  not,  in  whose  name?-i 


i.    (a)    Is  your  Town  or  City  Property  (Items  IS  and  17)  in  your  own  name?- 
ft)    If  not,  ID  whose  name? 


7.    M   I*  your  property  listed  at  assessed  valuationT- 
fl)>    If  not,  how  valued? 


(e)    What  is  the assosed  valuation?*.. 


t.    (a)    What  Insurance  do  you  carry  on  Farm  Buildings  (Item  18)?  >  On'TownorCityBail<liaci  (ItMal7)TlL. 

On  live  Stock  for  own  use  (Item  12)7  S , 


9.    (a)    Are  any  of  your  AsaeU  (except  Farm  Property  or  other  Real  Estate)  pledged,  assigned  or  hypothecated  in  aasrmyt^ 


'Jt.    fa)   Do  you  carry  li^e  Insurance?— 
(b>  What  amount?  t     -  . 


(c)  WhoisBeneficiaiyr- 


n.     M  Are  say  of  {be  Accounto,  Notes  or  Mortgages  o««d  by  your  (Items  21  to  26)  past  daeT- 
(b)   If  so,  state  aatonot*  and  reasons .   .,..,- -  ...— 


12.    (a)    What  amount  of  U.  S.  Government  Taws  did  you  pay  last  year?  t. 


Dt  and  other  represeaUtions  are  made  by  the  undersicned  for  the  purpose  of  procuring  credit,  obtaining  loans  and 
to  time.  If  any  unfavorable  change  in  my  financial  condition  occurs,  the  undersigned  agrees  to  immediately  notify  you, 
u  may  continue  to  rely  upon  this  statement  as  being  substantially  true  and  accurate  and  continuing  in  force  and  effect. 


The  foregoing  financial  statement 
unting  paper  with  you  from  time  to  ( 
and,  in  the  absence  of  such  notice,  you  may  continue  to  rely  upon  this  statement  as  being  substantially  I 

The  foregoing  financial  sUtement  and  all  details  pertaining  thereto  have  been  carefully  gone  over  by  the  undersigned,  and  I  hereby  solemnly  declare  and 
certjfx  Jiat_Jhex.set-J.orth.»  jxite.^jB4-4«virjtfe.a«^meat^jmy  fisacciai.  coiuUt|»iu^ 

Date  signed ,  19 .  Signed.-, — ; — 


(Name  of  Individual) 


We  hereby  certlly  that  the  tore(Oing  is  •  true  and  correct  copy  of  a  signed  financial  statement  of  the  above  mentioned  Individual  now  on  file  ir» 


Name  of  Member  Bank- 


Official  Slputure- 


CERTIFICATES  AND  REPORTS  393 

assets  follow  the  old  form.  The  author  believes  that  within  a 
short  time  good  accounting  practice  will  sanction  the  inclusion 
in  current  assets  of  all  current  prepayments.  Deferred  charges 
which  are  not  mere  prepayments  of  current  expenses  should 
appear  as  a  separate  group  following  fixed  assets. 

The  board  suggests  that  the  credit  files  of  member  banks 
should  include  information  concerning  the  following  matters : 

1.  The  nature  of  the  business  or  occupation  of  the  bor- 

rower. 

2.  If  an  individual,  information  as  to  his  indebtedness  and 

his  financial  responsibility. 

3.  If  a  firm  or  corporation,  a  balance  sheet  showing  quick 

assets,  slow  assets,  permanent  or  fixed  assets,  current 
liabilities  and  accounts,  short-term  loans,^  long-term 
loans,  capital  and  surplus. 

4.  All  contingent  liabilities,  such  as  indorsements,  guar- 

antees, etc. 

5.  Particulars  respecting  any  mortgage  debt  and  whether 

there  is  any  lien  on  current  assets. 

6.  Such  other  information  as  may  be  necessary  to  determine 

whether  the  borrower  is  entitled  to  credit  in  the  form 
of  short-term  loans. 

The  credit  files,  it  is  expected,  will  be  generally  adopted,  al- 
though it  is  to  be  noted  that  the  regulations  of  the  board  do  not 
absolutely  require  their  adoption. 

Statements  Requested  by  Credit  Managers 

Scientific  credit  granting  requires  the  employment  of  a  high 
degree  of  ability.  This  is  possessed  by  the  modern  credit  man- 
ager, or  he  could  not  occupy  the  important  position  which  he 
fills  today.  Nevertheless,  he  does  not  depend  solely  on  the  data 
which  he  can  secure  from  the  mercantile  agencies  and  similar 
sources.  Many  concerns  have  adopted  their  own  system  of  credit 
reports  from  present  and  prospective  customers. 


394  AUDITING— GENERAL  PRINCIPLES 

National  Association  of  Credit  Men's  Form. — The  form 
recommended  and  indorsed  by  the  National  Association  of  Credit 
Men  does  not  differ  materially  from  that  used  by  bankers,  but  it 
is  believed  that  the  exact  form  is  of  interest  to  those  who  are 
anxious  to  ascertain  the  point  of  view  of  men  to  whom  reports 
are  frequently  addressed.  As  stated  elsewhere,  the  auditor  who 
prepares  his  reports  in  a  form  easily  read  and  easily  under- 
stood by  those  for  whom  they  are  intended  will  be  the  most 
successful. 

Preceding  the  form  is  the  following  pertinent  observation : 

Large  assets  are  not  always  necessary  to  the  creation  of  credit.  What 
is  most  desirable  is,  that  credit  be  in  relative  proportion  to  the  actual 
assets.  The  giver  of  credit  is  a  contributor  of  capital,  and  becomes,  in  a 
certain  sense,  a  partner  of  the  debtor,  and,  as  such,  has  a  natural  right  to 
complete  information  of  the  debtor's  condition  at  all  times. 

Just  as  in  the  case  of  the  forms  of  statements  asked  for  by 
bankers,'  so  the  credit  men's  form  indicates  the  business  man's 
desire,  when  surveying  a  financial  situation,  to  have  the  assets 
stated  in  the  order  of  their  availability,  starting  with  the  most 
liquid,  and  the  liabilities  in  the  order  of  urgency  as  to  payment. 
When  it  is  realized  with  what  unanimity  bankers  and  credit  men 
indicate  their  preference  for  a  form  of  financial  statement  in  which 
assets  and  liabilities  are  arranged  in  the  manner  above  mentioned, 
it  is  all  the  more  surprising  that  so  many  corporations  still  persist 
in  publishing  their  balance  sheets  in  a  form  which  sets  forth  fixed 
assets  as  first  and  cash  as  last  among  the  assets,  and  capital  stock 
as  first  and  surplus  as  last  among  the  liabilities,  when  in  fact 
neither  one  of  the  latter  is  an  actual  liability. 

It  is  evident  from  the  phraseology  and  arrangement  of  the 
form  of  statement  recommended  by  the  National  Association  of 
Credit  Men,  that  reserves  for  doubtful  accounts  properly  are  in- 
tended to  be  deducted  from  receivables  before  stating  the  amount 
or  value  thereof,  and  that  depreciation  reserves  are  likewise  to  be 

'  See  pages  378-380,  382-385,  387-392. 


CERTIFICATES  AND  REPORTS 


395 


PROPERTY  STATEMENT 


^oAl  Adoptvd  ftnd  Recommanded  t 


For  the  purpose  of  obtaiiiiiig;  merchandise  from  yo;i  on  credit,  we  make  the  foUowing^tatement  in  writing/  intending  that  yoo 
•honld  rely  thereon  respecting  &xr  financial  condition  as  of  (Date) , ^_ 19 


(AH  questions  should  be  answered.    When  no  figures  are  inserted,  write  word  "None.") 

ASSETS 

Cash  in  hand 

UABIUTIBS 

For  MERCHANDISE: 
A««tint«  owinpr  not  due 

Cash  in  bank 



Accounts  owing  by  customers,  good  and 
ooUectible.  not  pledifed  or  sold 

Arrvmnfa  owinfr  past  due 

Notes  owing  by  customers,  good  and  ool- 
lecUble.  not  pledeed  or  sold 

KntM  paynhlfi  for  jUdae. 

For  BORROWED  MONEY: 

Trade  Acceptances  receivable,  not  pledged 
or  sold 



Notes  or  debU  payable  to  others  (includ- 
ing- relatives  and  friends^ 

Merchandise:  (not  on  consignment  or  con- 
ditional sale.)    (How  valued:  Cost 

Deposits  of  money  with  us.     (Describe) 

Market          \ 

Other  quick  asseU: 

Owing-for  Taxes  (city,  state  and  federal) 

Owing^  for  Rental 

TOTAL  QUICK  ASSETS 

TOTAL  QUICK  LIABILITIES 

Machinery:     (How  valued;    Cost 

Debt  secured  by  mortgage    on    land    or 
buildings 

Fixtures   and  othef  Equipment       (How 

Debt  secured  by  chattel  mortgage  or  other 

Debt  secured  by  iudfrment 

Other  liabilities: 
rDe8cribe> 

Notes  and  Accounts  owing  from  officers, 
employees,  or  others  not  customers 

Other  asseU: 

. 

TOTAL  LIABILITIES 

rDescribel 

NET  WORTH                      1  Common 

Surplus  and   Undivided 
Plx)fits 



- 

TOTAL  ASSETS 

TOTAL 

What  books  of  accotmt  do  you  keep? 

Was  this  statement  made  from  those  books? 


Do  you  keep  cost  records  ?_ 


Do  you  sell  or  pledge  yotir  accounts  to  creditors,  banks,  finance  companies  or  others? .     If  so  w] 

pledged?  $ What  amount  of  your  accounts  have  you  sold  or  pledged  during  the  past  twelve  months?  $._ 

Are  any  creditors  secured  by  mortgage  or  lien  of  any  sort?.^ If  so,  how? 


Are  lyiy  claims  in  attorneys'  hands  or  suits  against  you? 

Have  yon  merchandise  on  consignment  or  conditional  sale? 

If  business  property  is  leased,  for  what  term  and  what  rental?. 

Name  and  locality  of  your  bank  or  banks 

Location  and  kind  of  business 


If  so,  what  amount?    |_ 


Under  the  laws  of  what  state  is  your  business  incorporated  ?_ 
Previous  business  experience 


It  is  important  that  every  question  on  both  sides  of  this  sheet  be  correctly  answered  and  that  the  blanks  be  carefully  filled  in. 
In  answering  questions  involving  amounu  write  the  word  "none"  where  figures  do  not  apply.  You  will  find  it  advantageous  to  keep 
«  copy  of  this  sut«n>«st  (or  compwison  with  the  showiog  you  will  be  able  t«  make  a  year  beocc. 


396 


AUDITING— GENERAL  PRINCIPLES 


On  Merchandise  $ On  Buildings  $_ 

Other  Eqtiipment  t 

Is  any  insurance  assigned? What  .'>.moant?_ 

Amount  o£  life  insurance  for  benefit  of  business  $ 

With  what  companies 


INSUftANCB 

Machinery  $_ 


Employers'  liability  $_ 
To  whom  ? 


.PixturAi  $_ 


^SUMMARY  OF  PROFIT  AND  LOSS 

Inventory  of  Mdse.  beginning  of  fiscal 

Sales  last  fiscal  vear 

ment) 

Income  from  all  other  sources 

Cost  of  Mdse.  purchased  during  the  year 

Inventory  of  Mdse.  at  close  of  year 

Total  Income  for  year 

losses,  etc. 

Less  Total  Expenses 

TOTAL  EXPENSES 

NET  PROFIT  FOR  YEAR 



RECORD  OF  LAND  AND  BUILDINGS 

titie  in  name  of 

Description  and  location 

Book  value 

Assessed 
value 

Amount  of 
Encumbrances 

To  whom 

BUY  PRINCIPALLY  FROM  THE  FOLLOWING  CONCERNS 


Names 

Addresses 

•  Amotnt  Owing 

ppen  Account 

Notes 

Names  and  Addresses  of  Partners,  or  if  Corporation,  of  Officers. 


The  foregoing  statement  has  been  carefully  read  (both  printed  and  written  matter)  and  is  in  all  respects  complete,  accurate  and 
truthful.  It  discloses  to  you  the  true  state  of  my  (our)  financial  condition  on  the  date  above  stated.  Since  that  time  there  has  been  no 
material  unfavorable  change  in  my  (our)  finau^icl  condition;  and  if  any  such  change  takes  place  I  (we)  will  give  you  notice.  Until 
such  notice  is  given,  you  are  to  regard  this  as  a  continuing  statement. 


Name  of  Individual,  Firm  or  Corporation_ 


Signed  by. 
Street 


Date  of  signing  statement    ^ , 
Form  Jt. 


CERTIFICATES  AND  REPORTS  397 

deducted  from  the  assets  to  which  they  apply,  and  the  net  value 
of  such  assets  entered  in  the  statement. 

The  importance  to  the  grantor  of  credit  of  knowing  whether 
or  not  any  of  the  assets  have  been  hypothecated  or  are  encum- 
bered by  liens  of  any  description,  is  evident  from  the  statement. 
Bitter  experience  has  taught  credit  men  that  this  is  one  of  the 
most  vital  elements  involved  in  a  credit  situation. 

Forms  Issued  by  Mercantile  Agencies 

To  complete  the  presentation  of  the  forms  in  general  use 
throughout  the  United  States,  we  will  next  consider  the  ones 
issued  by  two  leading  mercantile  agencies.  These  forms  are 
supplied  to  practically  every  business  concern,  and  are  therefore 
more  familiar  to  the  average  business  man  than  any  others.  The 
arrangement  of  these  forms  is  not  ideal,  and  the  information 
which  may  be  gathered  from  them  falls  far  short  of  that  supplied 
in  forms  used  by  the  bankers'  and  credit  men's  associations.  It 
is  possible  that  the  agencies  do  not  feel  at  liberty  to  request  a 
statement  as  full  as  the  others,  but  it  is  obvious  that  their  forms 
could  be  improved  without  seriously  affecting  their  chances  of 
securing  information. 

It  has  been  suggested  that  the  mercantile  agencies,  in  addi- 
tion to  requiring  information  on  their  own  forms,  call  for 
financial  statements  certified  to  by  professional  auditors.  It 
would  be  entirely  feasible  to  assign  preferential  ratings  to  con- 
cerns which  furnish  satisfactory  audited  statements.  The  mer- 
cantile agencies  would  assume  no  more  risk  than  they  now 
incur;  credit  grantors  would  secure  information  vastly  more 
trustworthy  than  that  which  is  usually  furnished;  and  the 
concerns  which  furnish  the  audited  statements  would  properly 
benefit,  as  compared  with  the  concerns  which  would  not  or 
could  not  submit  their  accounts  to  the  scrutiny  of  independent 
and  disinterested  auditors. 

The  corporation  forms  in  use  by  the  two  large  agencies.  Dun's 
and  Bradstreet's,  are  as  follows: 


63 — Statement  of  incorporated  Co. 
SEKT  out Ko RETURNED 

BosiKEss  Established  1849. 

THE   BRADSTREET   COMPANY, 

IXCOHPOKATKD. 

Executive  Offices,  346  and  348  Broadway,  New  York. 


OFFICES  IN  THE  PrtNCIPAL  CITIES  OF  THE  UNITED  STATES,  CANADA,  CUBA,  MEXICO,  AUSTRALIA,  AMD  IN  LONDON,  EN(jLAND» 
WITH  AN  ESTABLISHED  LIST  OF  CORRESPONDENTS  THROUGHOUT  THE  CIVILIZED  WORLD. 


NEW  YORK  OFFICE— 346  and  348  Broadway. 


New  York  City, 192 


M 


We  respectfully  request  that  you  furnish  us  a  statement  of 
your  financial  condition,  on  the  within  form,  in  such  detail  as 
you  may  elect,  with  a  view  to  insure  the  correctness  of  our 
report.  By  so  doing  the  chances  of  error  will  be  lessened  and 
confidence  inspired  in  the  minds  of  grantors  of  credit. 

Those  of  whom  you  buy  must  get  information  regarding 
your  responsibility,  and  employ  The  Bradstreet  Company  to 
make  the  necessary  investigation.  That  we  may  be  better 
enabled  to  serve  them  and  yourself  is  the  sole  object  in  making 
this  request. 

We  ask  such  attention  as  the  subject  deserves. 

THE  BRADSTREET  COMPANY. 

-    7-20'210in 

Per.... 


63 — Stotement  Incorporated  Oo. 


.1©. 


Statement  made  by. 
Corporate  Style 


Business 

Where  located — 

NAME  OF  CITY  OR  VILLAGE. 


COUNTY 

STREET  AND  NUMBER STATE. 

Date  Of  Charter — .- 

Incorporated  in  what  State.^ 

Commenced  when 

Succeeding  whom , 


OFFICERS. 

Full  Civen  and  Surnames. 

President 

Residence. 

DIRECTORS. 


Full  Cicen  and  Surnames. 


399 


CAPITAL 
Authorised                          Subscribed 
Common  Stock,    -    $ S .........        $. 


Preferred  Stock,    -   ^ S f.... 

How  Paid  in: 

In  cash.     -------       $ ........ 

Patents,  trade-marks,  patterns,  etc.,     -        S 

In  other  property,    ....      -        $ % 

Give  particulars  and  the  value  of  each  kind  of  property 


ASSETS, 1 9 

Cash  In  bank,.  --- $ ........... 

Cashonhiind,  -.....-..---         

Notes  receivable,  actual  value, .-      -  -^ - 

Accounts  receivable,  actual  value,        ....... ^^.^ . 

Merchandise  (finished  and  unfinished).        -.-.-. ........ 

Baw  Material,  ---.---.---•  . .. 

Machinery  and  fixtures,  -      -...-.-.. 

Real  Estate,      ---      --       -       -      -      -      -      -       -       -         - — 

Other  Investments  (specify) f - 


TOTAL  ASSETS. »-. 

How  much,  If  any,  of  above  Accounts  Receivable  have  been  assigned 

or  pledged  for  loans, S 

LIABILITIES, r-— 19 

Capital  stock  paid  in,      ^      ------*-      •       *— 

Surplus  and  undivided  profits,       ,....---• 

Bills  payable,    .....--s---- 

Accounts  payable,    -.--------- 

Bonded  debt,    --.-.-----»- 

Mortgage  on  real  estate  (not  included  as  Bonded  debt),  -       -       - 

Chattel  mortgage  on  all  kinds  of  property,         -       - 

Borrowed  money  from  banks  (not  included  above),  -      ...  .. 

••  ••  "    Individuals  (not  Included  above),-      -      - 

All  other.  UabiUties. ^ 

TOTAL  UABILITIES. »-- 


How  much.  If  any,  of  the  above  indebtedness  Is  past  due,  $ OVER 

400 


Amount  of  animal  business.   -.------ 

Amount  of  annual  expenses,  -------- 

Annual  dividend 

Surplus  (not  including  undivided  profits),   -       -       -       -       - 

Indebtedness  of  company  to  stockbolders  included  in  liabilities. 
Amount  of  Insurance  on  merchandise,  ------ 

Amount  of  insurance  on  buildings  and  plant,     -       -       -       - 

Ever  had  a  Are;  if  so,  give  particulars 


Is  plant  protected  by  automatic  sprinklers. 
Other  interests  of  principal  directors 


Bank  with. 


TRADE  REFERENCES  from  whom  PRINCIPAL  PURCHAses  arc  made. 


Name... 
Address. 

Name 

Address. 
Name... 
Address. 

Name 

Address. 
Name... 
Address. 
Name... 
Address. 


Give  Address  of  Each. 


Amount  Owing 


REMARKS. 


Sign  here. 


VOL.  I — 26 


Official  Signature. 


401 


fOR  THE  PROMOTION  AND  PROTECTION  OF  CREDIT 


BJSTABLISMar?    1841 


The  Mercantile  A<3enicy 

R.  G.  DUN    a:    CO. 

principal  Offices:  Dun  Building,  290  Broadway*  Nevr York  City 


Branch  Office*  in  the  Principal  Cities  qf  the  World 


yp — 


f*Stateinejits''  as  an  Aid  in  Determining  Credits 

"'A  WELL  MANAGED  CREDIT  amounts  to  ten  fold  the  funds  of  a 
inerchant:  And  he  gains  as  much  by  his  credit  as  if  he  had  ten  times  as 
much  money.  This  maxim  is  generally  received  among  all  merchants. 
Credit,  therefore,  is  the  greatest  wealth  to  everyone^  who  carries  on  com- 
merce." In  commercial  countries  the  use  of  credit  In  the  place  of  money 
vastly  exceeds  the  use  of  money.  Goods  sold  and  delivered  in  exchange 
for  promises  to  pay  money  va^stly  excefed  in  value  goods  sold  and  deliverfed 
in  exchange  for  money. 

In  a  credit  transaction  it  is  the  right  of  one  party  to  receive'  and  the 
duty  of  the  other  to  give  information  sufficient  to  enable  the  one  pro- 
posmg  to  become  a  creditor  to  form  an  intelligent  opinion  as  to  the 
probable  ability  of  the  one  proposing  to  become  a  debtor  to  fulfill  his 
promise  to  pay.  The  object  of  The  Mercantile  Agency  is  to  obtain  and 
communicate  information  relating  to  the  an\punt  of  credit  which  one 
party  to  a  credit  transaction  may  pruidently  give  arid  the  other  party- 
may  prudently  accept.  The  disaster  to  one  through  accepting  too  much 
may  be  greater  than  the  disaster  to  the  other  through  giving  too  much. 
The  usefulness  to  both  the  two  classes  of  parties  of  their  availing  them- 
selves of  the  service  of  The  Mercantile  Agency  for  ^that  purpose  has 
;been  proved  by  their  experience  through  all  the  years  since  1841, 

These  are  the  grounds  ujMJri.  which  we  respectfully  make  application 
lor  the  information  indicated  by  the  form  of  this  "-Statemerit,"  a  state- 
ment which' it  is  our  intention  to  communicate  to  such  of  our  subscribers 
as  may  have '  occasion  to  consider  the  subject  of  credit  transactions 
between  the, maker  of  the  statement  and  themselves.  The  usefulness  of 
isuch  statements  to  those  who  make  them  has  been  so  abundantly  proved 
by  experience  that  the  making  of  them  has  become  the  common  practice. 
That  usefulness  is  f oWid  not  only  in  the  obtaining  of  credit,  but  in  the 
warning  not  to  accept  credit  too  much  in  amount  or  niaturing  at  times 
when  there  may  be  an  inability  tc>  pay.  Statements  made  upon  the  results 
of  a  careful  examination  of  things  as  they  really-  are  and  under  a  dis- 
position to  avoid  the  common  error  pf  an -overvaluation .  of  assets  are 
protective  to  debtor  and  creditor  alike. 

Information  not  expressly  called  for  by  this  printed  form,  which  inay 
serve  to  prove  or  indicate  the  degree  of  proljable  accuracy  of  figures,  or 
which  should  be  considered  both  by  him  who  gives  and  him  who  accep|;s 
credit,  is  requested,  and  may  be  stated  in  a  paper  attached  to  the  form 
and  identified  by  a  signature  and  date.  It  is  recommended  that  a  copy* 
gi  the  Statement  be  placed  l^pon  the  files  of  the  person  who  makes  it. 

R.  G.  r>UN  S:  CO. 

402 


CERTIFICATES  AND  REPORTS  403 


STATSMBNT— rona  D  (M.  T.) 

STATEMENT  AS  A  BASIS  FOR  CREDIT  MADE  TO 
THE     MERCANTILE     AGENCY 

R.  G.  DUN  &  CO. 

By ...„ ..., ....,..-...» ,r : • a  Corporation, 

Engaged  in - - : - Bu»ineM 

At County  of' State  of 

Date  to  which  all  the  ite;ns  of  the  statement  relate -19 - 

When  incorporated — .... Unde*  laws  of. — _...... 

'Authorized  Capital  Stock,  $....__„ iJo.  of^ shares':  preferred , common.,.„ J*ar  value,  $ 

Amount  of  Capital  ■Stock  subscribed,  $.. „ Amount  paid  in  (in  cash),  $ „..,..„ .■. 

Amount  paid  in  otherwise  than  cash  and  how,  $ » „ 


Limit  of  indebtedness  allowed,  $; Bonded  debt,  $ drawing  interest  at per  cent. 

Bonds  secured  by , _.. .-. Is  there  a  sinking  fuiidt... 

A\SS&  I  S.    {tered  um  the  word  NONBi 

Merchandise  on  hand  at  cash  val^e,     .  $ ........./ — 


Value  of  fixtures,     .     ,     .     ;     .     .  •  .     . 

Accounts  receivable  at  realizable  value,    . 

Notes  receivable  at  realizable  value,'   

Cash  on  hand,   '.     .     .  

Cash  in  bank,    .     .     _.. 

Real  estate  and'  buildingrs  owned  by  <^.    _-. i. 

Other  assets  consisting  of j — .. ......    .-. , 


Total  assets, f. -.... — 

Any  past  due  indebtedness,  and  if  any,  how  much  t  $ , :....;. 

If  any  of  the  above  accounts  are  pledged,  state  the  amount,  $ 

Are  there  .any  existing  liens  on  personal  property  not  mentioned  abovet    If  so,  whatl. 


LIABILITIES.  |S?«ru."hr;^rd*?oNB} 

For, merchandise  (open  account),      .     .  | _ 

For  merchandise   (notes  payable),     .     .     .„_ __. 

Loans  from  bank,     ..«.,.-.     ...» . 

Loans  from  other  sources 

Mortgages  on  real  estate,    .     ••    _ 

Other  obligations, ■_ 

Capital  stock  issued _.,.' 

Surplus  in  use  as  Capital, _.. 

Undivided  profits,. •.     . „ 

Total $ „ _ 


Contingent  liabilities  upon  bills  of  exchange,  endorsements,  guarantees,  etc.,  $.. 


Annual  business  amouhts  to  $ Bank  with _ 1 .; ■, 

Do  you  ^eep  books  of  account  of  the  business  t — „ _ „ 

If  so,  what  books? , _ .,..: 

Is  the  statement  o$  value  of  stock  on  hand  miade  upon  the  basis  of  an  inventory  actually  taken  f    And  if  sd,  on  what 

date? A : ,..„ _ 

What  in  your  opinion  is  the  total  amount  of  your  assets  and  of  your  liabilities  as  they  are  at  the  date  of  signing 

this  statement?    Total  assets,  $ ^ Total  liabilities,  $ _ ; 

Fire  Protection  :    State  its  general  nature — ^pijblic  fire  department,  sprinkler  system,  fire  extinguishers,  night  watch- 
man, etc ; ,..: : , ^...:. 


Insurance  :    On  Merchandise,  $ .^ .^ _ ; ;0n  Buildings,  $ , , 

Did  you  ever  suffer  a  fire  loss? If  so,  where  and.whent 

Did  fire  originate  on  your  premises? ,. ,.„.._ : , ....,, ^ 

Do  you  carry  employer's  liability  insurance? i _ „ _ 

Officers:    President, „. ;....».„_., . .Vice-President» * _..i„.i 

Secretary, Treasurer, ., G^nl  Manager...... ^ „ „ 

Names  of  Directors: _ >_ 


Date  of  signing  statement..: . 19 


404 


AUDITING— GENERAL  PRINCIPLES 


IMPORTANT 

fOndly  give  flie  names  of  a  few  houses  from  whom  you  make  your  largest  purchases. 


HAME 

STREET  ADDRESS 

CITV  AND  STATE 

AMOUNT  OWINC 

$ 

CHAPTER  XX 

CERTIFICATES  AND  REPORTS  (Continued) 

The  discussion  in  the  previous  chapter  is  not  complete  with- 
out reference  to  the  effect  of  liens  upon  assets,  form  of  income 
accounts,  and  graphic  charts.    These  will  be  discussed  here. 

Liens  and  Hypothecations 

Instances  are  known  of  certified  balance  sheets  which  have 
shown  accounts  receivable  and  merchandise  inventories  among  the 
assets  without  any  qualification,  when  really  they  were  pledged  as 
security  for  loans,  and  thus  were  not  assets  in  the  sense  in  which 
anyone  using  the  balance  sheets  was  entitled  to  assume. 

A  concern  has  accounts  receivable  of  $10,000,  stock-in-trade 
of  $10,000,  and  accounts  and  bills  payable  of  $15,000.  If  the 
latter  are  entirely  unsecured,  a  prospective  creditor  might  extend 
further  credit  if  the  concern's  standing  is  good,  on  the  theory  that 
in  the  event  of  bankruptcy  there  could  be  a  shrinkage  in  the  assets 
of  25  per  cent  before  a  creditor  would  lose  anything.  But  suppose 
it  is  found  that  all  of  the  accounts  receivable  have  been  assigned 
to,  and  a  chattel  mortgage  on  the  stock  taken  by,  a  creditor  for 
$10,000.  This  means  that  in  bankruptcy  the  unsecured  creditors 
would  probably  receive  nothing,  or,  at  best,  lose  50  per  cent  of 
their  claims  if  the  shrinkage  in  assets  was  only  25  per  cent. 

The  professional  auditor  must  never  certify  to  a  balance  sheet  with- 
out fully  considering  the  possibilities  of  liens  upon  the  assets,  and  if 
any  are  discovered,  such  liens  must  be  plainly  indicated  on  the  face  of 
the  balance  sheet  or  mentioned  in  the  certificate;  otherwise  he  is  guilty  of 
suppressing  material  information  and  can  probably  be  held  responsible 
in  damages  to  anyone  relying  thereon  who  suffers  loss  in  consequence. 

If  there  is  any  difficulty  in  securing  information  of  this  nature, 

405 


406  AUDITING— GENERAL  PRINCIPLES 

the  auditor  may  have  to  ask  the  question  shown  in  the  Credit 
Men's  standard  form.  If  he  finds  no  trace  of  Hens,  and  if  the 
officers  or  partners  state  in  writing  that  there  are  none,  he  cannot 
be  held  neghgent.  It  is  wrong,  however,  to  rely  on  not  finding  any 
evidence;  there  should  be  affirmative  proof  that  no  liens  exist. 

Forms  of  Income  Account 

An  income  account  or  statement  is  one  which  assembles  all 
income  and  expenses,  or  gains  and  losses,  for  a  stated  period.  It 
is  identical  with  the  ^'revenue"  statement  sometimes  presented, 
but  since  the  term  *' revenue"  is  usually  used  to  designate  one 
side  only  of  an  income  account,  the  term  is  not  properly  applicable 
to  a  statement  which  includes  expenses  as  well  as  income. 
Formerly  to  a  considerable  extent,  and  now  to  a  limited  extent, 
the  word  *' income"  is  used  for  only  one  side  of  an  account;  the 
practice,  however,  is  steadily  decreasing.  The  author  has  no 
objection  to  the  use  of  the  term  "profit  and  loss"  in  published 
statements;  but  it  has  not  grown  in  favor  among  accountants 
and,  as  accepted  accounting  terminology  should  consist  of  the 
terms  most  frequently  used,  it  is  suggested  that  the  use  of  the 
terms  "profit  and  loss"  and  "loss  and  gain"  be  limited  to  ledger 
captions  and  to  describe  specific  ledger  accounts,  and  that  the 
term  "income  account"  be  used  as  a  caption  for  the  general 
statement  which  accompanies  a  balance  sheet. 

The  income  statement  may  be  divided  into  as  many  sections 
as  are  desirable  or  necessary.  The  student  of  accountancy  is 
usually  taught  to  prepare  it  in  two  sections,  the  first  being  called 
the  trading  or  manufacturing  account,  and  the  second  the  general 
profit  and  loss  account.  This  illustrates  the  principles  of  group- 
ing and  permits  the  calculation  of  percentages  which  are  ex- 
tremely valuable  for  comparative  purposes.  The  trading  or 
manufacturing  account  usually  shows  on  one  side  net  sales,  and 
on  the  other  prime  costs  of  sales,  i.e.,  materials  used,  labor,  and 
other  direct  expenses.  In  some  cases  other  expenses  are  included, 
such  as  rent,  interest,  taxes,  etc. 


CERTIFICATES  AND  REPORTS  4^7 

In  modern  practice  it  is  not  customary  to  submit  a  trading  or 
a  manufacturing  account  under  these  captions.  The  experienced 
auditor  or  accountant  compiles  an  income  account  suited  to  the 
requirements  of  the  enterprise  upon  which  he  is  reporting,  and  in 
a  form  understandable  to  those  who  are  to  use  the  report. 

Illustration. — The  following  condensed  form  of  income 
account  was  submitted  to  the  St.  Louis  Congress  of  Accountants, 
in  1904,  by  Sir  A.  Lowes  Dickinson,  C.P.A.: 

Gross   Earnings    (whether   sales   of   products,    transportation 

earnings,  professional  earnings,  etc.) $ 

Deduct — Cost  of  Manufacture  or  Operation: 

(a)  Manufacture  (for  a  manufacturing  concern) : 

Labor $ 

Material 

General  Manufacturing  Expenses 

(b)  Cost  of   Operation   (for  concerns  not 

manufacturing) : 

(Under  suitable  headings  according 

to  the  nature  of  the  business) 

Gross  Profits $ 

Other  Earnings 


Deduct: 

Expenses  of  Sale  (manufacturing  business 

only) ^ 

Expenses  of  Management  (if  distinct  from 

operation) 

Net  Profits  from  Operations 


Deduct: 

Interest  on  Bonds 

Other  Fixed  Charges 

Surplus  for  the  year 

Extraordinary  Profits  (detailed) 

Surplus  brought  forward  from  preceding  year . 


Deduct: 

Extraordinary  Charges  not  applicable  to 

the  operations  of  the  year $. 

Interest  and  Dividend  on  Stocks 


Surplus  carried  forward , 


408  AUDITING— GENERAL  PRINCIPLES 

If  further  information  is  required,  the  condensed  statement  is 
supported  by  schedules  or  exhibits  which  go  into  as  much  detail 
as  is  necessary. 

Form  Used  in  Examination  for  C.P.A.  Degree. — The  fol- 
lowing form  of  statement  was  used  in  the  examination  held  by  the 
American  Institute  of  Accountants,  May  i8,  1921: 

Condensed  Profit  and  Loss  Statement 
for  the  calendar  year  1920 

Gross  Sales  (shipments) $240,000.00 

Less:  Return  Sales  and  Allowances 5,000.00 

Net  Sales $235,000.00 

Deduct: 

Cost  of  Goods  Sold  (shipped) 153,300.00 

Gross  Profits  on  Sales $  81,700.00 

Deduct: 

Selling  and  Administrative  Expenses 32,675.00 

Net  Profit  on  Operations $  49,025.00 

Add: 

Net  Financial  Income 975-00 

Net  Profit  for  the  calendar  year $  50,000.00 


No  special  provision  is  made  in  this  form  for  depreciation  and 
taxes.  It  cannot  be  assumed  that  those  two  items  are  included 
among  administrative  expenses.  The  term  *'net  financial  in- 
come" is  not  in  general  use  and  is  unintelligible  to  the  average 
man. 

Comparisons  to  Be  Shown. — The  auditor  should  strive  so  to 
arrange  the  accounts  as  to  show  a  comparison  with  previous 
periods;  also,  if  the  nature  of  the  business  permits,  unit  costs  or 
earnings  should  be  shown.  For  instance,  the  accounts  of  a  taxi- 
cab  company,  if  properly  set  up,  show  the  average  gross  earnings 
of  cabs  per  day.  They  also  show  the  operating  cost  per  mile. 
Perhaps  the  simplest  illustration  is  a  blast  furnace.  It  is  rela- 
tively easy  to  determine  the  cost  of  producing  a  ton  of  pig  iron, 


CERTIFICATES  AND  REPORTS  4^9 

but  the  figures  are  of  little  value  unless  the  output  is  shown  along 
with  the  average  cost.  The  production  for  one  week  may  be 
10,000  tons  at  an  average  cost  of  $8  per  ton;  if  the  production 
the  next  week  is  15,000  tons  at  a  cost  of  $8  per  ton,  the  natural 
inquiry  is:  Why  is  not  the  cost  proportionately  less  upon  the 
greater  output?  If  the  cost  per  ton  is  reported  separately  from 
the  production,  attention  may  not  be  called  to  the  possibility 
that  lower  costs  are  in  order. 

The  ratio  of  each  class  of  expense  to  the  total  volume  of  busi- 
ness is  always  interesting.  In  dull  times  certain  so-called  fixed 
charges  may  not  be  expected  to  vary,  but  there  are  other  classes 
of  expenses  which  should  fluctuate  ratably  with  the  volume  of 
business. 

The  auditor  who  states  the  accounts  of  a  number  of  concerns 
in  the  same  line  of  business  can  readily  acquire  a  knowledge  of 
income  and  costs  which  he  may  impart  for  the  benefit  of  all  at 
the  expense  of  none.  He  must  not  divulge  to  one  client  the  affairs 
of  another,  but  if  he  ascertains  that  the  office  staff  of  one  whole- 
sale grocer  costs  i  per  cent  per  annum  of  the  sales,  while  another 
costs  one-half  of  i  per  cent  and  is  equally  or  more  efficient,  he 
certainly  is  justified  in  making  a  special  investigation  into  the 
matter,  and  cannot  be  criticized  for  reporting  that  i  per  cent  is 
excessive. 

General  Provision  for  Depreciation,  Taxes,  etc. — The* 
expression,  *' balance  available  for  depreciation,  amortization, 
depletion,  and  taxes,"  is  very  had  practice.  Bankers  seem  fd~^ 
think  that  interest  can  be  met  out  of  the  general  reserves,  men- 
tioned above.  For  a  limited  period  this  is  true,  except  as  to 
taxes,  but  even  then  the  postponement  may  be  for  a  year  only. 
Depreciation  reserves  may  be  available  for  several  years.  De- 
pletion alone  may  be  permanent.  But  it  is  not  good  practice  in 
published  statements  to  omit  the  amounts  reserved  in  the  books, 
or  to  indicate  that  such  reserves  may  be  used  for  the  payment 
of  interest. 


410  AUDITING— GENERAL  PRINCIPLES 

GRAPHIC   CHARTS 

Use  of  Charts  and  Graphs 

The  use  of  charts  by  engineers  probably  dates  back  to  the 
early  days  of  that  profession.  The  use  of  charts  by  accountants 
is  of  a  more  recent  date.  It  is  not  as  common  as  it  should  be. 
This  is  due  to  the  general  attitude  of  the  client  or  business  man 
who  is  unfamiliar  with  the  value  of  such  means  of  presenting 
facts.  The  auditor  is  at  fault  if  he  does  not  ascertain  whether 
the  client  is  interested  in  charts  and  follow  this  inquiry  by  suffi- 
cient explanation  so  that  when  a  chart  forms  a  part  of  a  report 
its  value  is  appreciated. 

Essentials  of  a  Good  Chart 

Charts  must  be  simply  and  neatly  drawn.  A  chart  elabo- 
rately lettered  but  inaccurately  drawn  loses  its  value,  although 
such  charts  are  common.  Those  using  charts  expect  to  obtain 
at  a  glance  the  information  which  the  chart  purports  to  convey. 
The  auditor  must  be  cautioned  that  the  value  of  the  chart  is  not 
to  be  lessened  by  introducing  too  much  extraneous  material.  A 
title  which  is  concise  and  self-explanatory  is  an  indispensable  part 
of  a  chart. 

It  is  easy  to  exaggerate  the  facts  illustrated  by  altering  the 
scale  to  which  the  chart  is  plotted.  Care  and  skill  in  the  prepa- 
ration of  charts  are  essential;  but  a  little  practice  should  enable 
the  auditor  to  develop  statistics  in  graphical  form.  Where 
necessary,  a  scale  should  be  given  to  assist  in  interpreting  the 
chart. 

Types  of  Charts 

There  are  three  types  of  charts  or  graphs  with  which  the 
auditor  should  be  famiUar.  These  are  generally  referred  to  as: 
the  circle  type,  the  bar  or  column  type,  and  the  curve  or  broken 
line  type.  As  a  rule,  only  one  of  these  types  of  graphs  can  be 
used  to  illustrate  clearly  certain  facts  or  data.     It  is  very  neces- 


CERTIFICATES  AND  REPORTS 


411 


sary  that  the  auditor  should  know  which  type  of  chart  to  use  iii 
each  case,  but  with  experience  in  the  preparation  of  charts  he 
should  have  no  difficulty  in  making  a  decision. 

The  charts  shown  on  the  succeeding  pages  are  illustrative  of 
the  principles  that  make  up  a  good  chart. 

Circle  Type 

Two  circles  are  shown  below.  The  area  of  one  represents  the 
total  selling  expenses  (100  per  cent).  The  expenses  that  make 
up  the  total  are  shown  in  the  sectors  of  the  circle.  This  is  a 
form  that  is  popular  with  some  business  men  although  it  possesses 
but  few  advantages  and  is  not  readily  adaptable  to  extensive 


DISTRIBUTION  OF  SELLING  EXPENSES 


ANALYSIS  OF  REVENUE  FROM  SALES 


development.  This  can  best  be  seen  by  examining  the  other 
circle.  This  area  represents  the  analysis  of  the  revenue  from 
sales.  It  will  be  noticed  that  the  gain  is  shown  as  a  sector  of  the 
circle,  but  if  it  is  necessary  to  indicate  a  loss,  it  cannot  be  clearly 
illustrated  with  a  circle  type  chart  in  which  case  it  is  evident 
that  some  other  form  must  be  substituted. 


Bar  Type 

The  bar  type  chart  on  page  413  illustrates  the  analysis  of  the 
revenue  from  sales  over  a  period  of  four  years  by  means  of  propor- 


412  AUDITING— GENERAL  PRINCIPLES 

tionate  length  columns.  This  chart  brings  out  not  only  the  rela- 
tions  which  the  costs  and  expenses  bear  to  each  other  in  a  given 
year,  but  the  relation  between  similar  costs  or  expenses  in  the 
different  years.  The  loss  is  easily  indicated  by  a  negative 
position  being  placed  below  the  base  line. 

The  client  is  interested  to  learn  the  cause  of  the  losses  in  the 
years  1918,1919,  and  1920.  It  is  quite  evident  that  the  operating 
expenses  and  rent  have  remained  nearly  constant  during  the 
four  years,  yet  the  results  change  from  a  profit  in  191 7  to  a  loss 
in  the  other  years.  The  cause  for  this  decided  drop  lies  in  the 
fluctuation  of  the  cost  of  merchandise  sold.  The  greater  the 
cost,  the  greater  the  loss,  as  is  evident  in  19 19  when  the  cost  of 
merchandise  sold  amounted  to  74  per  cent  of  the  total  sales 
revenue  and  the  loss  was  10  per  cent,  whereas  in  191 7  the  cost  of 
merchandise  sold  was  55  per  cent. 

A  glance  at  the  chart  suffices  to  explain  the  reason  for  this 
unfavorable  result. 

Attention  is  directed  to  the  use  of  a  legend  giving  the  meaning 
of  the  symbols  used  in  marking  the  columns,  which  also  increases 
its  value  for  ready  reference.  The  gain  or  loss  might  be  shown  in 
red,  the  rent  in  blue,  the  operating  expenses  in  black,  and  the 
cost  of  merchandise  sold  in  green. 

Broken  Line  or  Curve  Type 

The  third  type  of  graph,  as  illustrated  on  pages  414  and  415,  is 
the  broken  line  or  curve  type.  This  type  of  chart  does  not  possess 
all  the  advantages  of  the  bar  type  and  lacks  the  flexibility  of  the 
latter,  but  it  is  also  popular  with  some  business  men.  An  effec- 
tive use  of  this  type  is  given  in  two  parts;  one  shows  the  sales  by 
months  for  two  years  and  the  other  accumulated  monthly  sales 
for  the  same  periods.  This  is  a  very  good  type  to  use  where 
comparisons  are  of  great  importance.  The  charts  can  be  pre- 
pared at  the  commencement  of  a  fiscal  year,  showing  compara  tive 
sales  by  months  and  the  accumulative  totals  for  the  preceding 
year.     In  an  examination  of  the  upper  chart  it  will  be  noted  that 


CERTIFICATES  AND  REPORTS 


413 


O 

o 


o 

w 

W 


H ' 1 ^■ 


saiBg  JO  1U80  ja«i 


o  o     >^    o 


414 


AUDITING— GENERAL  PRINCIPLES 


during  1919  the  monthly  sales  in  January  were  $14,000,  going 
up  to  $18,000  in  May,  down  to  $16,000  in  August,  up  to  $19,- 
000  in  November,  and  down  to  $17,000  in  December.  These 
figures  are  shown  by  the  dotted  line.  The  year  1920  (solid  line) 
commences  with  $16,000,  a  gain  over  the  previous  year,  as 
clearly  shown  by  the  chart.  In  May  the  increase  is  not  only 
maintained,  but  the  rate  of  gain  is  increased. 


28 


26 


24 


a  22 

a 
« 20 

1 

GD 

2  18 


16 


14 


12 


Monthly  Sales 

y 

lor 
1919  and  1920 

/ 

\ 

/ 

\, 

^£- 

y 

/ 

\ 

/ 

\ 

y^ 

J 

/ 

\ 

y 

/ 

/ 

■^^^ 

-. 

-isja 

j—j 

_^^ 

/ 

\ 

z^ 

^ 

Jan.     Feb.      Mar.      Apr.      May      June     July      Aug.     Sept.     Oct.     Nov.      Dec. 

In  Other  words,  a  chart  will  show  a  trend  which  columns  of 
figures  fail  to  emphasize.  The  best  place  for  a  chart  of  this  kind 
is  on  the  wall  of  an  office  or  on  a  map  holder.  It  may  be  kept 
private  by  having  a  cover  over  it  or  it  may  be  rolled  up.  The 
auditor  may  submit  a  sample  chart,  based  on  past  experience, 
which  will  indicate  the  possibilities  of  the  plan. 

For  a  more  thorough  discussion  of  the  principles  and  for  a 
wider  range  of  illustrations,  the  reader  is  referred  to  "How  to 
Make  and  Use  Graphic  Charts"  by  Haskell,  and  "Graphic 
Methods  for  Presenting  Facts"  by  Brinton.  The  following 
quotation  is  taken  from  the  latter  book: 


CERTIFICATES  AND  REPORTS 


415 


Though  accurate  data  and  real  facts  are  valuable,  when  it  comes  to 
getting  results,  the  manner  of  presentation  is  ordinarily  more  important 
than  the  facts  themselves.  .  .  .  Unless  the  facts  are  presented  in  a  clear 
and  interesting  manner,  they  are  about  as  effective  as  a  phonograph 
record  with  the  phonograph  missing. 

If  it  were  more  generally  realized  how  much  depends  upon  the 
method  of  presenting  facts,  as  compared  with  the  facts  themselves, 
there  would  be  a  great  increase  in  the  use  of  graphic  methods  of 
presentation. 

If  the  facts  were  put  in  graphic  form,  not  only  would  there  be  a 
great  saving  in  the  time  of  the  readers,  but  there  would  be  a  gain  to 


^ou 

/ 

220 
200 
180 

/ 

/ 

Accumulated  Sales 
for 
1919  and  1920 

/ 

/ 

/ 

/ 

/ 

/ 

160 
140 
ion 

/ 

7 

/ 

/ 

s* 

/ 

/ 

inn 

/ 

'/ 

/' 

80 

/ 

// 

/ 

/ 

// 

/ 

40 

>^ 

^^-^ 

/ 

20 

/■ 

r 

0 

<y 

Jan.      Feb.      Mar.      Apr.     May      June     July      Aug.  .  Sept.      Oct.      Nov.      Dec. 


4l6  AUDITING— GENERAL  PRINCIPLES 

society,  because  more  facts  could  be  absorbed  and  with  less  danger  of 
misinterpretation. 

Value  of  Comparative  Statistics 

The  head  of  the  fidelity  department  of  a  large  surety  com- 
pany states  that  a  great  many  irregularities  and  defalcations, 
especially  those  which  take  the  form  of  the  padding  of  pay-rolls, 
would  be  uncovered  in  their  infancy  if  the  managements  of  fac- 
tories and  commercial  business  houses  would  pay  more  attention 
to  their  accounts  and  have  their  accounting  departments  compile 
comparative  statistics  of  their  businesses — and  then  study  them. 
He  cites  the  case  of  a  cashier  of  a  manufacturing  concern  who  had 
been  padding  the  pay-roll  for  years.  It  was  the  practice  of  this 
concern  to  have  the  pay-roll  approved  by  the  foreman,  the  super- 
intendent, and  the  general  manager.  It  was  sent  to  the  cashier, 
who  made  alterations  in  the  total  figures,  drew  a  cheque  for  the 
raised  amount,  cashed  it,  and  paid  off  the  men.  The  pay-roll 
did  not  leave  the  cashier  after  it  was  given  to  him  to  draw  the 
cheques,  and  he  made  the  distribution  for  posting.  This  went 
on  for  years,  the  cashier  each  week  pocketing  from  $200  to  $900. 
At  last  a  change  of  executives  brought  in  a  manager  who  had  been 
accustomed  to  make  his  accounts  show  in  statistical  form  the 
economic  condition  of  his  business.  He  had  been  employed  in 
the  same  line  before  and  he  knew  that  the  price  of  raw  material, 
the  rates  for  wages,  and  the  various  expenses  were  about  the  same 
as  in  his  former  place;  but  the  income  account  showed  a  much 
smaller  net  income.  It  was  soon  found  that  this  was  due  to  the 
high  charge  for  labor.  Upon  analysis  of  this  charge  the  stealings 
were  discovered. 

This  is  but  one  instance,  yet  it  is  easy  to  see  that  by  showing 
the  result  of  a  business  in  graphic  form  so  that  the  relation  of  the 
various  elements,  one  to  another,  is  easily  seen,  abnormal  condi- 
tions are  at  once  detected.  Some  may  say  that  these  things  are 
interesting  and  all  very  well  if  one  had  the  time  and  money  to 
get  them  up.    They  do  not  realize  the  cost  of  not  getting  them  up. 


CERTIFICATES  AND  REPORTS  417 

Statistics  compiled  by  one  of  the  large  bonding  companies  in  the 
United  States  show  that  during  the  first  six  months  of  192 1 
claims  amounting  to  more  than  $i,25o,cx>o  were  made  against 
this  one  company  on  account  of  defalcations.  The  claims  made 
by  banks  alone  amounted  to  almost  $500,000. 

What  Not  to  Report 

As  heretofore  stated,  it  is  not  wise  to  report  unimportant 
errors,  etc.,  chiefly  because  it  accomplishes  no  useful  purpose, 
even  if  true.  In  any  event  criticisms  of  this  nature  should  never 
be  made  without  confirmation  from  the  office  staff,  because  they 
may  be  able  to  come  back  with  proof  that  the  errors  or  omissions 
are  apparent  only. 

Likewise,  long  schedules  of  trade  debtors  and  creditors  are 
superfluous.  For  some  years  public  accountants  made  it  a  rule 
to  furnish  their  clients  with  detailed  schedules  of  accounts  re- 
ceivable and  payable,  believing  that  such  information  was  de- 
sired by  them  and  would  be  of  value.  They  found,  however, 
that  in  nine  cases  out  of  ten  these  schedules  were  not  referred  to, 
and  that  in  the  one  case  remaining  the  schedules  desired  were  the 
latest  ones  rather  than  the  ones  submitted  by  the  auditors,  which 
were  usually  one  or  two  months  old.  The  practice  was  therefore 
quite  generally  abandoned,  and  such  schedules  are  now  furnished 
only  on  request. 

In  reports  in  which  special  circumstances  govern,  such  as 
changes  in  partnership,  it  may  be  necessary  to  submit  detailed 
schedules.  The  above  remarks  refer  only  to  the  ordinary 
periodical  audit  and  to  balance  sheet  audits. 

A  schedule  of  vouchers  and  paid  cheques  not  submitted  is 
sometimes  of  importance;  but,  as  a  rule,  it  is  preferable  to  prepare 
such  a  list  before  completing  the  audit  and  to  hand  a  duplicate  to 
the  bookkeeper,  so  that  the  missing  vouchers  may  be  located. 
After  as  many  as  possible  are  located,  the  corrected  list  should  be 
handed  to  the  proprietor  with  a  request  that  he  examine  it.  If 
further  inquiry  or  search  is  requested,  it  should  be  made  before 

VOL.  I — 27 


41 8  AUDITING— GENERAL  PRINCIPLES 

the  audit  is  completed.     If  no  further  attention  is  required,  the 
schedule  is  not  important  enough  to  be  put  in  a  report. 

The  auditor  should  scan  the  list  of  outstanding  unpaid  bank 
cheques.  A  cheque  is  sometimes  issued  to  close  a  disputed 
account,  etc.  This  fact  renders  it  desirable,  from  both  the 
client's  and  the  auditor's  point  of  view,  that  it  be  used.  The  in- 
spection should  apply  only  to  those  outstanding  an  unreasonable 
length  of  time.  If  any  doubt  arises  the  matter  should  have 
attention  at  once,  but  no  mention  of  it  need  be  made  in  the  report 
unless  some  irregularity  is  discovered. 

Restrictions  on  Clients  Use  of  Reports 

Mention  has  been  made  of  the  attempted  but  unauthorized 
use  of  auditors'  reports  and  certificates.  This  is  obviated  by  a 
judicious  selection  of  clients;  but  perhaps  a  cHent  who  has  paid 
for  a  report  will  feel  at  liberty  to  use  part  of  the  contents  without 
disclosing  the  context.  Anticipating  this  possibility,  experienced 
auditors  bind  and  fasten  their  reports  securely  together,  and 
page  them  in  such  a  way  that  a  part  cannot  be  used  without 
revealing  the  fact  that  it  is  not  complete. 

It  does  not  seem  feasible  to  suggest  any  plan  whereby  clients 
or  others  can  be  prevented  from  quoting  from  a  report.  So  long  as 
the  statement  is  not  made  that  the  quotation  represents  conclu- 
sions of  fact  to  which  an  auditor  has  certified,  it  may  not  be 
objectionable;  but  it  is  remarkable  how  critical  business  men  are 
regarding  the  connection,  real  or  alleged,  of  a  professional  auditor 
with  men  or  enterprises  of  doubtful  character. 

In  one  case  a  well-known  firm  of  auditors  had  for  many  years 
audited  and  certified  to  the  accounts  of  a  small  but  prosperous 
corporation.  A  large  concern  bought  the  small  company  and 
consolidated  it  with  a  number  of  others.  The  bankers  who 
marketed  the  stock  stated  in  their  circulars  that  the  accounts  of 
the  small  company  had  been  audited  by  the  well-known  firm, 
whereas  the  accounts  of  all  the  others,  and  of  the  holding  com- 
pany, had  been  audited  by  an  audit  (stationery)  company.     The 


CERTIFICATES  AND  REPORTS  419 

latter  continued  the  audit  until  the  holding  company  went  into 
hopeless  bankruptcy.  The  well-known  firm  was  not  connected 
with  the  enterprise  after  its  clients  sold  out;  but  after  the  bank- 
ruptcy occurred,  a  large  banking  house  intimated  that  the  men- 
tion of  the  firm's  name  in  a  circular  relative  to  a  company  with 
such  an  objectionable  history  seriously  affected  their  own 
attitude  in  employing  the  firm  for  accountancy  work. 

This  is  an  extreme  case,  but  it  illustrates  the  great  importance 
to  an  auditor  of  restricting  the  use  of  his  name  to  professional  work 
which  is  creditable  to  him  in  every  way,  and  of  making  engage- 
ments only  with  clients  or  promoters  who  are  beyond  suspicion. 

Misleading  Advertisements 

Auditors  are  sometimes  requested  to  compile  data  or  statistics, 
or  to  prepare  calculations  for  use  in  new  enterprises.  Great  care 
must  be  taken  to  restrict  the  use  of  the  reports  to  the  purposes  for 
which  they  are  submitted. 

Recently  an  issue  of  preferred  stock  was  advertised  and  a 
large  bonus  of  common  stock  was  offered  as  an  inducement  to 
purchase.     The  following  statement  was  made  inter  alia: 

Based  on  reports  of  A  &  B,  certified  public  accountants,  on  manufac- 
turing costs  and  selling  prices  from  six  months*  operation  at  part  capacity 
of  plant  at  Blank  City,  earnings  at  full  capacity  are  estimated  at 

OVER  35  PER  CENT  ON  THE  COMMON  STOCK  AFTER  PAYMENT  OF  7  PER  CENT 
dividends  on  PREFERRED  STOCK. 

Clearly,  the  purpose  of  the  foregoing  was  to  deceive.  It  was  so 
printed  that  everyone  gathered  the  impression  that  the  auditors 
had  made  a  report  to  the  effect  that  earnings  equal  to  35  per  cent 
on  the  common  stock  might  be  expected. 

It  may  become  necessary  for  auditors  to  print  on  their  sta- 
tionery some  form  of  notice  to  the  effect  that  no  public  use  can 
be  made  of  the  information  conveyed  unless  a  memorandum 
setting  forth  the  form  of  the  proposed  use  is  first  submitted  for 
their  inspection.     Unquestionably  many  advertisements,  parti- 


420  AUDITING— GENERAL  PRINCIPLES 

cularly  bankers'  circulars,  contain  misleading  compilations  and 
conclusions  purporting  to  be  drawn  from  accountants'  reports; 
in  many  cases  the  reports  themselves  are  not  published.  The 
most  flagrant  cases  are  those  which  conceal  the  aggregates  of 
federal  taxes,  depletion,  depreciation,  etc.,  during  the  war  years, 
making  it  appear  that  those  years  were  highly  prosperous  ones, 
whereas  many  concerns  which  apparently  made  large  profits 
were  worse  off,  net,  at  the  end  of  19 19  than  at  the  beginning  of 
191 7.  The  practice  is  a  vicious  one.  It  is  difficult  to  prevent 
because  some  individual  cases  do  not  seem  to  be  objectionable. 
Probably  the  only  solution  is  for  the  American  Institute  to 
prescribe  the  form  which  quotations  from  accountants'  reports 
may  take. 

Compulsory  Reports 

Compared  with  our  lack  of  legal  requirements,  it  is  of  inter- 
est to  note  what  reports  must  be  prepared  in  England  and 
Canada. 

The  following  is  an  extract  from  Table  A  of  the  EngUsh 
Companies  Act  of  1908: 

Section  106.  Once  at  least  in  every  year  the  directors  shall  lay  be- 
fore the  company  in  general  meeting  a  profit  and  loss  account  for  the  period 
since  the  preceding  account  or  (in  the  case  of  the  first  account)  since  the 
incorporation  of  the  company,  made  up  to  a  date  not  more  than  six  months 
before  such  meeting. 

Section  107.  A  balance  sheet  shall  be  made  out  in  every  year  and 
laid  before  the  company  in  general  meeting  made  up  to  a  date  not  more 
than  six  months  before  such  meeting.  The  balance  sheet  shall  be  accom- 
panied by  a  report  of  the  directors  as  to  the  state  of  the  company's  affairs, 
and  the  amount  which  they  recommend  to  be  paid  by  way  of  dividend, 
and  the  amount,  if  any,  which  they  propose  to  carry  to  a  reserve  fund. 

Section  108.  A  copy  of  the  balance  sheet  and  report  shall,  seven  days 
previously  to  the  meeting,  be  sent  to  the  persons  entitled  to  receive  notices 
of  general  meetings  in  the  manner  in  which  notices  are  to  be  given  here- 
under. 

Audit:  Section  109.  Auditors  shall  be  appointed  and  their  duties 
regulated  in  accordance  with  sections  112  and  113  of  the  Companies 


CERTIFICATES  AND  REPORTS  421 

(Consolidation)  Act,  1908,  or  any  statutory  modifications  thereof  for  the 
time  being  in  force. 

The  following  is  an  extract  from  the  Dominion  Companies 
Act,  R.  S.  C,  Cap.  79  (1908  as  amended  in  1917): 

Section  94a.  (i)  Every  company  shall  at  each  annual  general  meeting 
appoint  an  auditor  or  auditors  to  hold  office  until  the  next  annual  general 
meeting. 

(2)  If  an  appointment  of  auditors  is  not  made  at  an  annual  general 
meeting,  the  Secretary  of  State  of  Canada  may,  on  the  application  of  any 
shareholder  of  the  company,  appoint  an  auditor  of  the  company  for  the 
current  year,  and  fix  the  remuneration  to  be  paid  to  him  by  the  company 
for  his  services. 

(3)  A  director  or  officer  of  the  company  shall  not  be  capable  of  being 
appointed  auditor  of  the  company. 

(4)  A  person,  other  than  a  retiring  auditor,  shall  not  be  capable  of 
being  appointed  auditor  at  an  annual  general  meeting  unless  notice  of  an 
intention  to  nominate  that  person  to  the  office  of  auditor  has  been  given 
by  a  shareholder  to  the  company  not  less  than  fourteen  days  before  the 
annual  general  meeting;  and  the  company  shall  send  a  copy  of  any  such 
notice  to  the  retiring  auditor,  and  shall  give  notice  thereof  to  the  sharehold- 
ers, either  by  advertisement  or  in  any  other  mode  provided  by  the  by-laws 
of  the  company  not  less  than  seven  days  before  the  annual  general  meeting: 

Provided  that  if,  after  notice  of  the  intention  to  nominate  an  auditor 
has  been  so  given,  an  annual  general  meeting  is  called  for  a  date  fourteen 
days  or  less  after  the  notice  has  been  given,  the  notice,  though  not  given 
within  the  time  required  by  this  provision,  shall  be  deemed  to  have  been 
properly  given  for  the  purposes  thereof,  and  the  notice  to  be  sent  or  given 
by  the  company  may,  instead  of  being  sent  or  given  within  the  time  re- 
quired by  this  provision,  be  sent  or  given  at  the  same  time  as  the  notice 
of  the  annual  general  meeting:  Provided,  however,  that  a  person  other 
than  a  retiring  auditor  may  be  appointed  auditor  of  the  company  at  an 
annual  general  meeting  as  hereinbefore  provided,  upon  a  resolution  passed 
by  the  votes  of  shareholders  present  in  person  or  by  proxy  and  holding  at 
least  two-thirds  of  the  subscribed  stock  represented  at  the  meeting. 

(5)  The  first  auditors  of  the  company  may  be  appointed  by  the  direc- 
tors before  the  first  annual  general  meeting,  and  if  so  appointed  shall  hold 
office  until  the  first  annual  general  meeting,  unless  previously  removed  by 
a  resolution  of  the  company  in  general  meeting,  in  which  case  the  company 
at  that  meeting  may  appoint  auditors. 


422  AUDITING— GENERAL  PRINCIPLES 

(6)  The  directors  may  fill  any  casual  vacancy  in  the  office  of  auditors, 
but  while  any  such  vacancy  continues  the  surviving  or  continuing  auditor 
or  auditors,  if  any,  may  act. 

(7)  The  remuneration  of  the  auditors  of  a  company  shall  be  fixed  by 
the  company  in  general  meeting,  except  that  the  remuneration  of  any 
auditors  appointed  before  the  first  annual  general  meeting,  or  to  fill  any 
casual  vacancy,  may  be  fixed  by  the  directors.  ^ 


«  7-8  Geo.  v.,  c.  25,  s.  II.     Imp.  Act,  1908,3.  112. 


CHAPTER  XXI 
INVESTIGATIONS 

Part  of  the  work  of  the  professional  auditor  is  designated, 
not  as  an  audit,  but  as  an  investigation.  There  is  here  an 
actual  distinction,  just  as  the  work  of  the  accountant  may  be 
differentiated  from  that  of  an  auditor. 

For  the  purposes  of  this  book,  audits  and  investigations  are 
separated  only  as  to  the  special  points  to  be  observed  in  the  latter, 
it  being  assumed  that  in  many  investigations  a  complete  detailed 
audit  is  required,  and  that  in  others  a  balance  sheet  audit  is 
essential. 

Investigations  are  usually  undertaken  in  connection  with  the 
sale  of  a  business  to  a  corporation  or  other  purchaser  for  the  pur- 
pose of  obtaining  special  information  relative  to  finances  or 
general  affairs,  or  with  respect  to  alleged  fraudulent  transactions, 
or  with  respect  to  the  profits  derived  from  the  manufacture  of 
infringing  articles,  etc. 

A  curious  feature  connected  with  investigations,  which  rarely 
arises  with  respect  to  audits,  is  the  attempt  on  the  part  of  dis- 
reputable promoters,  or  of  those  with  no  reputation  at  all,  to 
retain  the  services  of  reputable  auditors.  Usually  in  such  cases 
the  enterprise  to  be  investigated  lacks  books. of  account  and 
promises  Httle  for  the  future,  or  a  company  has  been  formed 
with  a  large  capital  stock  issue  against  mining  claims  or  some 
equally  uncertain  asset.  A  certificate  is  desired  for  publication, 
or  for  private  exhibition  to  prospective  investors. 

In  the  hands  of  an  honest  man,  an  auditor's  certificate  in  the 
ordinary  form  might  be  unobjectionable,  but  if  the  certificate  is 
in  the  possession  of  an  unscrupulous  promoter,  it  may  be  repre- 
sented to  be  an  unqualified  indorsement  of  the  enterprise  and  its 

423 


424  AUDITING— GENERAL  PRINCIPLES 

promoters,  and  there  are  enough  ignorant  investors  to  believe 
these  or  stronger  statements.  The  wise  auditor  never  permits 
his  certificate  to  be  so  used,  for  a  single  mistake  of  this  kind  in 
sizing  up  a  client  may  mean  the  loss  of  one's  reputation.  Suc- 
cessful auditors  can  take  no  chances  at  all  in  this  respect;  they 
must  be  more  particular  about  their  clients  than  a  bank  is  about 
its  customers. 

The  various  classes  of  investigations  and  the  special  features 
of  each  class  will  be  discussed  in  the  following  order: 

1 .  Upon  the  sale  or  purchase  of  a  business. 

2.  To  ascertain  information  required  by: 

(a)  Creditors,  prospective  creditors,  or  stockholders. 

(b)  Parties  to  litigation  or  disputes. 

3.  Investigation  of  suspected  fraud. 

SCOPE   OF  THE  WORK 

Instructions  from  Clients 

The  title  of  this  chapter  may  convey  the  impression  that  the 
work  to  be  done  is  more  or  less  restricted  in  its  scope,  and  that 
the  auditor  who  undertakes  an  investigation  for  a  special  purpose 
may  expect  to  receive  special  instructions,  differing  from  the  cir- 
cumstances under  which  he  would  be  willing  to  make  an  audit. 
It  is  not  claimed  that  an  auditor  would  insist  on  proceeding  with 
any  professional  work,  including  audits,  which  appeared  to  be 
even  remotely  in  opposition  to  his  clients'  wishes.  He  could 
withdraw,  and  this  would  be  the  only  proper  course  if  he  found 
himself  unable  to  comply  with  the  directions  of  those  for  whom 
his  work  was  intended. 

As  a  member  of  a  profession  with  high  ideals,  he  can  insist, 
or  in  the  exercise  of  his  full  prerogatives  he  can  demand,  that  in- 
structions outlining  the  scope  of  his  work,  or  the  form  of  his  certi- 
ficate and  report,  shall  accord  with  honorable  motives  and 
straightforward  dealing.  Otherwise,  he  cannot  proceed  without 
forfeiture  of  his  self-respect. 


INVESTIGATIONS  425 

If  the  instructions  are  incomplete  and  the  auditor  fails  to  in- 
terpret them  broadly,  so  as  to  include  all  of  the  results  which 
are  called  for  by  the  nature  of  the  case,  he  should  not  attempt  to 
excuse  his  deficient  results  by  falling  back  on  his  instructions. 
Therefore,  at  the  commencement  of  an  investigation  it  is  most 
important  that  specific  instructions  be  issued  by  the  client,  or  be 
prepared  by  the  auditor  and  confirmed  by  the  client. 

Working  Papers  to  Be  Preserved 

Following  up  his  instructions  from  the  client,  the  auditor 
issues  special  directions  to  his  own  staff.  The  remarks  on  working 
papers^  apply  with  full  force,  and,  in  addition,  special  care  must 
be  taken  to  preserve  all  data  bearing  on  the  adjustment  of  the 
accounts.  In  few  investigations  does  the  auditor's  report  show 
accounts  and  amounts  as  they  appear  on  the  books.  Even  if 
net  results  are  not  altered,  an  analysis  is  made  resulting  in  a 
different  arrangement  and  presentation. 

It  is  of  the  utmost  importance  that  working  sheets  be  pre- 
pared and  retained  which  show  in  absolute  detail  the  recon- 
ciliation of  the  original  book  figures  with  those  appearing 
in  the  final  report.  Neglect  of  this  precaution  may  subse- 
quently result  in  censure  for  neglect,  coupled  with  the  neces- 
sity of  duphcate  work,  for  which  a  charge  cannot,  or  should  not, 
be  made. 

In  some  cases  the  working  papers  of  an  audit  have  to  be  re- 
ferred to  after  the  report  is  submitted,  but  in  nearly  all  investiga- 
tions, questions  arise  after  the  work  is  completed  which  require 
reference  to  the  data  compiled  during  the  progress  of  the  work. 
Opinions  differ  regarding  the  length  of  time  working  papers 
should  be  preserved.  If  storage  space  is  available  and  not  too 
expensive,  it  is  desirable  to  hold  them  indefinitely;  if  storage 
space  is  expensive,  papers  may  be  destroyed  after  a  reasonable 
time  has  elapsed.  What  is  a  reasonable  time  depends  on  the 
circumstances  of  each  case. 

'Page  47. 


426  AUDITING— GENERAL  PRINCIPLES 

Detail  Which  May  Be  Omitted 

If  ^'investigation"  were  simply  another  name  for  an  audit, 
this  chapter  would  not  have  been  written. 

In  general  it  may  be  stated  that  since  an  investigation  is  not 
an  audit,  but  an  inquiry  into  specific  matters,  the  routine  re- 
quirements of  an  audit  as  outlined  in  this  book  may  be  omitted. 
Later  on,  the  features  which  must  not  be  omitted  will  be  discussed. 

Previous  Audits 

It  has  also  been  mentioned  that  in  an  ordinary  engagement 
the  auditor  often  finds  himself  to  be  the  first  professional  auditor 
who  has  been  consulted.  But  with  investigations,  which  are 
frequently  called  for  in  connection  with  consolidations  of  prosper- 
ous enterprises,  it  will  be  found  that  many  of  the  latter  have  had 
their  accounts  audited.  If  the  auditor  can  secure  the  reports  of 
such  examinations,  he  has  a  basis  upon  which  to  determine  what 
use  he  can  make  thereof.  Obviously  this  basis  depends  on  the 
standing  of  the  other  auditors  and  the  nature  of  their  reports. 

If  access  to  previous  reports  cannot  be  had,  the  auditor  should 
secure  permission  to  consult  with  the  previous  auditors  for  the 
purpose  of  securing  any  information  possible.  If  this  is  not  feas- 
ible, he  must  proceed  as  if  the  accounts  had  never  been  audited. 

Experience  has  demonstrated  that  failure  to  furnish  pertinent 
data  of  any  kind  raises  a  prima  facie  case  of  interested  conceal- 
ment against  those  who  reasonably  may  be  expected  to  furnish 
the  information.  When  information  such  as  may  be  contained 
in  previous  auditors'  reports  is  not  promptly  disclosed,  the 
auditor  is  charged  with  a  greater  degree  of  watchfulness  than  if 
the  existence  of  such  information  is  unknown. 

Where  Assets  Are  Appraised 

It  is  becoming  fairly  general  practice  in  investigations  to 
employ  appraisers  as  well  as  auditors.  The  former  must  take 
the  responsibility  for  physical  valuations  of  fixed  assets  items, 
and,  while  this  is  of  great  assistance  to  the  auditor,  he  should 


INVESTIGATIONS  427 

never  incorporate  their  valuations  in  his  accounts  without  con- 
sidering their  relation  to  the  income  account.  The  auditor 
should  steadfastly  maintain  that  he  cannot  state  the  net  income 
of  a  business  irrespective  of  an  examination  of  the  assets  and 
liabilities.  If  the  book  assets  must  be  adjusted  to  an  appraisal, 
the  income  account  may  require  adjustment  also.  The  word 
"may"  is  used  advisedly,  since  some  appraisal  companies  are 
inclined  to  overvalue  physical  assets.  It  is  pleasing  to  proprie- 
tors (which  may  explain  why  it  is  done),  but  it  does  not  always 
afford  a  reasonable  basis  for  a  writing  up  of  book  values  and  a 
consequent  adjustment  of  the  net  income. 

On  the  other  hand,  in  view  of  this  tendency,  any  insufficiency 
of  assets  shown  by  an  appraisal  should  be  reflected  in  the  income 
account. 

Definite  Report  Wanted 

In  order  that  there  may  be  no  misunderstanding,  it  should  be 
understood  that  the  author  does  not  advocate  submitting  sug- 
gestions and  criticisms  based  on  mere  hearsay,  or  on  incomplete 
information.  The  point  to  be  emphasized  is  that  all  facts  per- 
tinent to  the  inquiry  are  permissible  and  may  be  of  more  value 
than  a  mass  of  figures. 

Certain  adjustments  are  necessary  in  practically  all  investiga- 
tions, but  the  auditor  must  be  firm  in  arranging  the  results  and 
in  wording  his  report,  or  it  may  be  found  that  the  final  conclu- 
tions  are  far  from  representing  a  well-thought-out  opinion  of  the 
standing  of  the  business. 

Auditors  have  been  very  properly  warned  that  if  there  is 
nothing  definite  for  them  to  report,  they  should  not  be  led  into 
stating  that  if  the  expectations  of  the  promoter  are  realized  his 
estimates  of  the  net  income  are  correct. 

Handling  Books  and  Records 

Before  making  a  single  mark  of  any  description  in  a  record 
which  is  the  property  of  another,  the  auditor  should  ask  himself 


428  AUDITING— GENERAL  PRINCIPLES 

the  question:  ^'Is  there  any  possibility  of  these  records  being 
falsified,  and  might  it  embarrass  me  later  if  it  were  shown  that 
I  had  made  marks  herein?  "  In  every  case  the  question  should 
act  as  a  reminder  that  if  marks  are  warranted  they  should  be 
small,  neat,  and  so  made  as  to  be  readily  and  positively  identified 
on  any  subsequent  occasion. 

If  fraud  is  suspected,  it  is  always  desirable,  and  sometimes 
necessary,  that  no  marks  at  all  should  be  made.  In  such  a  case 
the  entries  which  are  falsified  should  be  rewritten  on  loose  sheets, 
paged  the  same  as  the  original  records,  and  the  correct  amounts 
shown  in  an  adjoining  column.  This  permits  a  summary  of  the 
fictitious  entries  being  made  up  at  any  time.  It  involves  an 
immense  amount  of  work,  however,  and  the  auditor  should  advise 
his  clients  of  its  possible  cost. 

False  Entries  Sometimes  Forgeries 

The  entry  of  an  incorrect  amoimt  in  a  book  of  record,  if  made 
with  intent  to  defraud,  is  forgery,  and  therefore  a  serious  crime. 

Frequently  false  entries  are  found  in  books  which  indicate 
that  the  one  responsible  therefor  has  misappropriated  an  equiva- 
lent sum  of  money,  but  it  may  be  difficult  to  produce  satisfactory 
evidence  as  to  when  and  how  the  defaulter  actually  took  the  cash. 

It  is  well  known  that  a  verdict  of  guilty  is  difficult  to  secure 
from  a  jury  when  the  evidence  consists  largely  of  complicated 
and  manipulated  accounts.  The  defaulter's  plea  that  his  books 
were  unfortunately  mixed  up,  but  that  he  never  stole  anything, 
appeals  to  the  sympathy  of  the  average  man.  If  it  can  be  shown 
conclusively,  however,  that  certain  entries  are  fraudulent  on  their 
face,  it  may  be  possible  to  prove  a  charge  of  forgery.  An  auditor 
should  always  be  familiar  with  the  law  of  his  own  state  on  this 
subject. 

The  Auditor  as  an  Expert  Witness 

Few  professional  auditors  escape  their  day  in  court  as  expert 
witnesses.     The  necessity  usually  arises  out  of  investigations 


INVESTIGATIONS  429 

where  fraud  or  disputes  are  known  to  exist,  but  experience  teaches 
that  fraud  may  be  discovered  in  any  audit,  and  in  cases  where  it 
is  least  expected.  Therefore  the  auditor  must  look  upon  himself 
at  all  times  as  a  potential  witness.  Neglect  to  give  proper  weight 
to  this  possibility  has  caused  considerable  embarrassment  on 
more  than  one  occasion  when  an  auditor  has  placed  someone  in 
charge  of  an  audit  who  is  not  qualified  to  make  a  creditable  wit- 
ness. Sometimes  assistants,  thoroughly  equipped  in  other  re- 
spects, are  constitutionally  unfitted  to  appear  as  expert  witnesses. 

Part  of  the  program  of  an  audit,  consequently,  is  a  provision 
for  the  substitution  of  an  experienced  senior  or  principal  as  soon 
as  the  work  has  gone  far  enough  to  warrant  the  assumption  that 
an  appearance  as  a  witness  is  probable. 

The  author  has  testified  as  an  expert  witness  scores  of  times, 
and  submits  the  following  suggestions  based  entirely  on  practical 
experience: 

I.  Preparation  Is  Always  Essential. — The  average  lawyer 
does  not  prepare  his  cases  properly.  This  is  because  the  majority 
are  settled  without  suit,  or  when  called  are  so  frequently  con- 
tinued from  time  to  time  that  he  finds  it  fairly  safe  to  take  a 
chance  of  waiting  until  the  trial  or  reference  is  on  before  going 
into  the  details  of  the  accounts  upon  which  he  purposes  to  examine 
the  accountant. 

This  makes  it  all  the  more  necessary  for  the  accountant  to 
be  ready.  Unfortunately,  the  lawyer's  excuses  are  received  with 
less  annoyance  than  the  accountant's,  and  the  latter  must  be  ready 
to  go  into  any  or  all  phases  of  the  matter  on  a  moment's  notice, 
or  the  lawyer,  and  through  him  the  client,  become  impatient. 

The  section  on  working  papers^  should  be  read  at  this  point. 
Failure  to  make  full  and  proper  memoranda  during  the  examina- 
tion is  as  annoying  subsequently  as  the  failure  to  find  data 
required,  either  because  it  is  not  properly  arranged  or  filed,  or 
because  the  query  raised  was  not  foreseen. 


See  page  47. 


430  AUDITING— GENERAL  PRINCIPLES 

2.  A  Witness  Can  Testify  to  His  Own  Work  Only.— 
While  an  expert  witness  is  permitted  to  present  synopses  and 
summaries  prepared  from  records  offered  in  evidence,  and  is  thus 
not  compelled  to  produce  his  results  item  by  item,  yet  he  must 
testify  that  the  results  to  which  he  testifies  are  his  own  prepa- 
ration and  not  the  work  of  others.  The  state  of  mind  of  the 
presiding  judge  usually  decides  this  point  when  there  is  any 
dispute. 

The  author  has  found  it  valuable  to  have  ready  for  inspection 
certain  of  the  working  papers  written  in  his  own  handwriting. 
The  attorney  for  the  other  side  almost  invariably  raises  this  point 
when  he  thinks  there  is  any  Hkelihood  of  any  of  the  work  having 
been  performed  by  others,  and  when  the  witness  has  a  large 
practice,  and  is  thought  to  be  dependent  largely  on  the  work  of 
assistants,  or  when  the  report  indicates  that  one  man  could  not 
possibly  have  compiled  all  of  the  data  within  a  limited  period  of 
time.  It  is  of  the  utmost  importance,  therefore,  that  the  witness 
should  be  ready  to  state  that  the  results  to  which  he  is  testifying 
are  his  own  work;  that  he  brought  the  figures  together;  that  if  he 
did  not  perform  all  of  the  detail  work,  it  was  done  under  his 
supervision,  and  that  he  presents  it  as  his  work.  Experienced 
judges  accept  this  explanation  and  permit  accountants  to  testify 
as  to  the  accuracy  of  work  done  by  assistants. 

3.  Information  Should  Not  Be  Volunteered. — ^As  an 
accountant  is  supposed  to  testify  to  facts  only,  he  makes  the  best 
impression  when  he  answers  questions  expHcitly  and  stops  when 
he  thinks  the  questions  have  been  answered. 

If  the  attorney  is  not  fully  conversant  with  the  details  of  the 
case,  the  accountant  should,  before  the  hearing  or  trial  com- 
mences, prepare  for  the  attorney  written  questions  designed  to 
bring  out  all  of  the  matter  favorable  to  his  cHent's  side  of  the 
case. 

The  auditor  should  never  be  asked  to  suppress  facts  within  his 
knowledge,  and  cannot  honestly  do  so,  no  matter  how  much 


INVESTIGATIONS  431 

pressure  is  brought  to  bear,  but  no  code  of  ethics  recommends,  or 
as  a  matter  of  fact  permits,  a  professional  man  to  volunteer  to 
outsiders,  or  to  the  opposing  side  in  litigation,  facts  which  would 
injure  his  cHent. 

The  accountant  having,  as  a  part  of  his  duty,  provided  the 
means  whereby  favorable  facts  will  be  disclosed,  must  in  every 
legitimate  way  guard  against  the  disclosure  of  unfavorable  facts. 
As  intimated  above,  he  must  answer  any  pertinent  question,  no 
matter  how  much  the  answer  may  hurt  his  client;  but  if  there  is 
any  possibility  of  such  a  question,  in  cross-examination,  being 
irrelevant,  or  improper,  he  should  give  his  own  attorney  plenty 
of  time  to  object  before  replying,  and  if  he  is  instructed  to  answer, 
his  duty  lies  solely  in  telling  the  truth,  and  there  should  be  no 
volunteering  of  information  for  which  the  question  does  not 
specifically  call. 

4.  Conclusions  and  Opinions. — Practitioners  differ  as  to 
how  far  an  accountant  is  justified  in  testifying  as  to  his  opinions 
when  the  facts  at  hand  may  not  be  conclusive  enough  for  him  to 
state  positively  that  his  testimony  is  founded  on  conclusions 
based  solely  on  facts  and  figures  contained  in  the  records  offered 
in  evidence. 

Frequently  the  records  are  incomplete,  but  enough  data  may 
have  been  compiled  to  warrant  a  definite  opinion  as  to  certain 
results.  When  the  witness  is  acting  in  good  faith,  and  is  in- 
terested only  in  seeing  that,  as  far  as  he  is  concerned,  substantial 
justice  is  being  done,  it  may  be  urged  that  his  duty  to  his  client 
requires  the  presentation  of  all  the  evidence  possible,  and  that 
the  other  side  can  be  depended  upon  to  object  to  anything  going 
in  unless  the  ground  work  of  relevancy  has  been  laid. 

On  the  other  hand,  it  is  contended  that  an  accountant,  as  a 
witness,  should  be  absolutely  impartial  and  disinterested,  that  he 
should  state  the  bare  truth  and  be  oblivious  of  which  side  it  might 
affect.  The  author  has  heard  this  argmnent  for  many  years, 
but  in  the  course  of  his  experience  which  has  brought  him  into 


432  AUDITING— GENERAL  PRINCIPLES 

contact,  on  one  side  or  the  other,  with  the  leading  accountants 
in  this  country,  he  has  invariably  found  that  the  accountants  are 
more  or  less  interested  in  their  side  and  the  presentation  of  the 
facts  favorable  to  their  side,  and  he  has  failed  to  detect  any  signs 
of  pure  disinterestedness  on  the  part  of  any  one  of  them. 

Furthermore,  he  has  found  in  many  instances  that  the  ac- 
countants have  been  better  advocates  for  their  clients  than  the 
attorneys  themselves,  this  being  demonstrated  not  only  by  their 
testimony  under  oath,  but  by  their  skill  in  suggesting  questions 
to  the  attorneys,  and  these  questions  have  been  directed  to  all 
witnesses,  and  not  to  those  only  who  are  examined  on  the 
accounts. 

To  sum  up :  the  present  practice  seems  to  be  for  accoimtants 
to  promote  in  all  legitimate  ways  the  success  of  the  side  of  litiga- 
tion on  which  they  are  retained,  and  they  are  not  found  to  be  un- 
concerned and  oblivious  of  results;  that  the  attorneys  and  parties 
to  the  cases  know  that  this  is  the  practice;  that  they  are  relying 
more  and  more  on  professional  auditors  to  assist  in  the  prepara- 
tion of  matters  in  litigation;  and  that  the  attorneys  and  others 
who  have  a  first-hand  knowledge  of  the  present  practice  do  not 
see  any  impropriety  in  it. 

The  author  has  no  criticism  to  make  of  this  procedure,  but 
on  the  contrary  believes  that  the  accountants  who  have  in  many 
cases  signally  helped  their  clients  by  extra  zeal  would  have  fallen 
short  of  their  full  duty  if  they  had  maintained  the  attitude  of  a 
machine  which  shows  final  results,  but  which  cannot  make  sug- 
gestions as  to  how  those  results  may  be  used. 

ON  SALE  OR  PURCHASE  OF  A  BUSINESS 

The  professional  auditor  is  now  being  consulted  frequently  by 
the  man  who  wishes  to  sell  as  well  as  the  man  who  wishes  to  buy. 
The  former  reahzes  that  the  services  of  an  independent  auditor 
are  of  the  utmost  value  to  him  in  stating  the  ramifications  of  his 
business  so  clearly  that  he  will  not  omit  any  favorable  aspects  in 


INVESTIGATIONS  433 

dealing  with  a  prospective  purchaser.  Likewise,  the  buyer  feels 
that  he  cannot  afford  to  depend  on  the  representations  of  the 
seller  or  on  his  own  judgment.  One  may  pay  too  high  a  price 
and  the  other  may  sell  at  too  low  a  price  unless  the  professional 
auditor  passes  upon  the  proposition. 

It  is  generally  recognized  by  leading  accountants  that  when 
an  auditor  represents  a  prospective  purchaser,  much  that  is 
necessary  in  an  ordinary  audit  may  be  omitted.  It  is  safe 
and  legitimate  to  assume  that  the  seller  will  not  underestimate 
his  profits,  or  his  assets,  and  that  he  will  not  overstate  his  lia- 
bilities. 

Briefly  stated,  if  the  auditor  finds  actual  net  earnings  and 
assets  equaling  the  representations,  and  no  more  liabilities  than 
are  claimed,  he  need  not  spend  unnecessary  time  on  an  inspec- 
tion of  the  expense  vouchers  and  similar  work. 

The  chief  points  of  difference  which  may  arise  between  an 
investigation  of  this  kind  and  an  audit,  are  the  following: 

(a)  Something  more  than  figures  wanted. 

(b)  Period  covered. 

(c)  Analysis  of  earnings  and  expenses. 

(d)  Future  requirements  and  economies. 

(e)  System  of  accounts. 

(f)  Elimination  of  unusual  items. 

(g)  Adjustments  and  qualifications, 
(h)  Errors  in  the  books. 

(i)    Investigation  on  behalf  of  a  retiring  partner  when  the 

business  is  being  sold  to  a  continuing  partner, 
(j)   Investigation  for  those  in  charge  of  reorganizations. 

(a)  Requirements 

These  will  be  discussed  in  order. 

Something  More  Than  Figures  Wanted. — The  prospec- 
tive purchaser  of  a  business  wants  to  know  as  much  of  its  past 
history  as  a  man  does  of  the  past  history  of  his  prospective 

VOL.  I — 28 


434  AUDITING— GENERAL  PRINCIPLES 

bride.  He  usually  contemplates  joining  fortunes  for  an  indefi- 
nite period,  and  his  associations  must  represent  more  than 
mere  financial  gain.  Who  is  better  equipped  to  pass  on  the 
enterprise  from  almost  every  point  of  view  than  an  experienced 
auditor? 

Most  accountants  feel  that  their  full  duty  has  been  discharged 
when  they  submit  a  balance  sheet  and  an  income  statement,  to- 
gether with  such  comments  thereon  as  modify  the  figures  sub- 
mitted. Outside  of  these  figures  they  will  not  go,  on  the  theory 
that  to  do  so  would  mean  a  departure  from  facts  into  the  realm  of 
theory. 

Nothing  could  be  more  inconsistent!  The  figures  shown  are, 
with  very  few  exceptions,  estimates  only.  The  stock-in-trade 
is  always  worth  something  more  or  less  than  the  inventory  valua- 
tion. The  fixed  assets  vary  in  value  to  such  an  extent  that  book 
valuations  are  usually  shown  because  actual  values  are  unknown. 
The  accounts  receivable  are  valued  on  past  experience,  which 
may  be  deceptive.  There  may  be  contingent  liabilities  of  large 
amount  unknown  and  not  provided  for.  Therefore,  certain 
conclusions  as  to  the  conduct  of  the  business,  the  trend  of  prices, 
and  other  general  information  may  be  compiled  by  the  auditor 
and  reported  upon  with  about  as  much  dependability  as  the 
accounts. 

What  does  a  prospective  purchaser  want?  It  is  not  enough 
that  the  report  of  the  auditor,  the  appraiser,  or  the  engineer  show 
that  the  assets,  as  represented,  are  in  existence  or  that  the  earn- 
ings equal  the  guaranteed  estimates.  It  is  of  quite  as  much  im- 
portance to  be  assured  that  the  management  as  it  existed  at  the 
time  of  the  examination  was  all  that  could  be  desired.  Assets  are 
sometimes  accumulated  and  earnings  realized  through  cumu- 
lative circumstances  which  are  no  longer  a  factor,  or  under 
the  administration  of  men  no  longer  connected  with  the  enter- 
prise. 

In  the  United  States,  new  industries  or  special  and  ingenious 
processes  may  have  been  responsible  for  large  profits  which  sub- 


INVESTIGATIONS  435 

sequently  become  reduced  through  the  natural  economic  law  of 
competition  and  imitation.  Capital  flows  to  unusually  profitable 
enterprises  as  surely  as  water  finds  its  level. 

Contingencies. — Suppose  the  business  imder  investigation 
has  shown  unusual  profits  up  to  the  date  of  the  last  balance  sheet. 
Is  the  auditor  charged  with  the  duty  of  forecasting  a  probable 
change?  Perhaps  not,  but  many  enterprises  have  failed  to  main- 
tain past  profits,  although  the  latter  have  been  actual,  and  the 
auditor's  certificates  thereto  true  in  all  respects.  In  some  cases 
bankruptcy  has  resulted  within  a  year  after  the  flotation  of  a 
stock  or  bond  issue,  due  entirely  to  a  drop  in  gross  profits  caused 
by  competition,  the  removal  of  tariff  protection,  compulsory  re- 
duction in  rates  by  public  authority  or  private  demand,  or 
reckless  or  fraudulent  practices. 

The  auditor  is  not  and  would  not  be  held  responsible  for  losses 
arising  out  of  these  contingencies,  but  if  the  downward  movement 
were  starting  during  the  course  of  his  examination,  should  he  not 
convey  his  impressions  to  his  client?  It  may  be  said  that  a  pro- 
spective purchaser  should  think  of  these  things  himself.  Perhaps 
he  should,  but  he  doesn't.  The  author  has  followed  this  line  of 
suggestion  more  or  less  for  some  years,  and  has  found  that  the 
comments  are  well  received  and  always  appreciated,  even  though 
his  advice  may  not  always  be  followed. 

Statistics. — An  auditor  who  expects  to  perform  a  consider- 
able amount  of  investigating  in  the  course  of  his  practice  will  find 
it  very  useful  to  compile  statistics  of  various  businesses.  This 
may  seem  to  be  a  formidable  undertaking,  but  it  may  not  be.  It 
so  happens  that  the  proprietors  of  a  business  will  hear  that  a 
certain  auditor  has  just  completed  an  examination  of  the  books 
of  someone  in  the  same  line  as  themselves.  They  feel  that  he 
has  acquired  special  knowledge  relative  to  methods,  etc.,  which 
may  be  beneficial  to  them.  It  should  be  remarked  in  passing 
that  only  in  the  rarest  cases  has  an  auditor  been  asked  to  reveal 


436  AUDITING— GENERAL  PRINCIPLES 

any  confidential  information  which   he   has   secured   from  a 
competitor. 

But  the  auditor  may  for  his  own  information  compile  statis- 
tics as  to  what  a  certain  kind  of  business  should  earn,  and  what 
its  expenses  and  costs  should  be.  Without  revealing  the  source 
of  his  information,  he  may  be  able  to  offer  constructive  sugges- 
tions or,  in  the  case  of  a  purchase  or  sale,  or  other  investigation, 
he  may  be  able  to  comment  more  intelligently  on  the  accounts 
than  if  he  were  dependent  entirely  on  the  data  compiled  in  each 
particular  case. 

Status  of  Accounts. — There  is  another  line  of  investigation 
which  is  not  often  reflected  in  a  report:  Are  the  accounts  to  which 
the  auditor  certifies,  prepared  directly  from  the  current  books  of 
account,  or  are  they  the  result  of  special  compilation?  If  the 
latter,  is  the  actual  state  of  the  books  an  indication  of  neglect 
or  ignorance?  Have  the  proprietors  kept  themselves  informed 
as  to  the  results  of  operations  through  monthly  or  other  fre- 
quent periodical  statements,  or  have  they  waited  for  definite 
results  until  the  end  of  their  fiscal  year,  when  an  inventory  is 
taken? 

Have  they,  therefore,  been  dependent  entirely  upon  intuitive 
knowledge,  which  is  possessed  more  or  less  (chiefly  less)  by  execu- 
tives who  scorn  theory  and  accounts,  and  who  boast  of  the  value 
of  practical  experience?  Are  the  departments  co-ordinated,  or 
do  they  run  independently  to  such  an  extent  that  one  does  not 
know  what  the  other  is  doing?  Is  it  a  fact  that  certain  depart- 
ments are  a  law  imto  themselves,  that  they  run  along  and  write 
up  copious  records  which  are  never  used  by  those  to  whom  they 
might  be  supposed  to  be  of  value? 

Conclusion. — All  of  these  queries  and  many  more  might  be 
answered  offhand  by  an  auditor  who  had  completed  an  investi- 
gation into  assets,  liabilities,  and  earnings,  but  he  could  not 
properly  report  thereon  unless  he  had  been  in  contact  with  every 


INVESTIGATIONS  437 

department  of  the  business.  Having  this  information,  why 
should  he  not  report  thereon  orally  or  in  writing? 

All  these  suggestions  have  a  bearing  on  the  two  thoughts 
which  are  uppermost  in  the  mind  of  a  prospective  purchaser, 
viz.:  *' Taking  everything  into  consideration,  is  the  business  a 
desirable  acquisition?  "  and  "How  much  is  it  worth? "  The  audi- 
tor may  not  wish  to  give  a  definite  answer  to  either  question,  but 
he  can  furnish  figures  and  other  information  which  are  of  the 
utmost  interest. 

The  auditor  should  insist  that  at  least  a  summary  of  the 
financial  statement  should  be  published  in  a  prospectus  when  the 
accountant's  name  is  given  therein.  Several  instances  have 
come  to  the  author's  attention  where  statements  made  by  the 
bankers  differed  materially  from  those  furnished  by  the  account- 
ants. In  one  case,  the  accountants  were  forced  to  defend 
themselves  in  one  of  the  financial  papers  by  repudiating  the 
information  published  by  the  bankers. 

(b)  Period  Covered 

As  stated  at  the  commencement  of  this  chapter,  the  auditor 
should  require  definite  instructions  before  starting  an  investiga- 
tion. These  instructions  usually  specify  the  period  to  be  covered. 
As  a  prospective  purchaser  wishes  to  know  absolutely  all  that  is 
possible  about  the  past,  it  is  usual  to  verify  the  earnings  for  as 
many  years  back  as  time  permits.  Three  years  is  a  minimum, 
while  ten  years  is  not  too  long  a  period  for  those  who  expect  to 
make  a  permanent  investment. 

As  will  be  pointed  out  later,  it  is  not  necessary  to  audit  the 
accounts  in  the  usual  sense.  An  analysis  is  all  that  is  required. 
Therefore,  it  is  very  little  more  work  to  cover  six  years  than  three, 
unless,  of  course,  the  records  for  past  years  are  incomplete  or  in- 
accurate. The  longer  the  period,  the  more  accurately  will  the 
trend  of  the  business  be  shown.  Most  enterprises  have  good  and 
poor  years,  and  the  respective  recurrence  of  these  is  of  great 
interest. 


438  AUDITING— GENERAL  PRINCIPLES 

In  no  event  should  the  results  of  two  or  more  years  be  lumped. 
A  big  year  and  a  small  year  may  make  a  satisfactory  average, 
but  few  wish  to  invest  in  a  business  where  the  small  year  is  the 
last.  Therefore,  each  year  must  be  shown  separately,  and 
averages  never  used  unless  the  actual  results  of  the  last  year  or 
two  are  equal  to  the  average. 

The  auditor  must  not  fail  to  inspect  the  results  between  the 
date  of  the  balance  sheet  and  the  time  of  the  examination.  The 
most  recent  month  should  be  compared  with  the  same  month 
for  previous  years,  and  if  an  unfavorable  result  is  shown,  the  fact 
should  be  reported. 

(c)  Analysis  of  Earnings  and  Expenses 

Gross  Income. — In  an  audit  it  is  always  important  to  verify 
the  gross  income.  In  many  investigations  the  prospective  pur- 
chaser is  greatly  interested  therein  and  is  almost  indifferent  with 
respect  to  the  net  income.  He  says  that  with  his  own  appraise- 
ment of  the  physical  property,  and  a  personal  knowledge  of  local 
conditions,  he  requires  nothing  additional  except  an  accurate 
statement  of  the  gross  receipts  or  earnings  of  the  enterprise  in 
order  to  determine  upon  the  price  he  is  willing  to  pay  for  the 
property.  The  reason  is  that  an  experienced  executive  knows, 
or  thinks  he  knows,  the  proper  ratio  of  operating  expenses 
which  will  be  incurred  under  proper  management,  and  it  is 
of  little  moment  to  him  how  much  the  old  management  has 
expended. 

This  procedure  is  followed  in  connection  with  the  sale  of 
public  utility  companies  oftener  than  with  any  other  class.  The 
sales  or  output  of  these  companies  are,  of  course,  more  nearly  con- 
stant and  dependable  than  with  trading  or  manufacturing  enter- 
prises. But  capable  men  in  nearly  all  lines  are  found  willing  to 
invest  in  a  business  with  which  they  are  familiar,  and,  if  reason- 
ably assured  of  a  minimum  of  gross  income,  will  undertake  to 
guarantee  a  maximum  of  operating  cost,  irrespective  of  what  the 
previous  owner  may  have  done. 


INVESTIGATIONS  439 

If  a  purchaser  is  chiefly  interested  in  gross  income,  the  auditor 
should  take  great  care  to  state  the  earnings  properly,  looking 
carefully  into  the  sources  of  revenue,  comparing  one  period  with 
another,  and  noting  any  deductions  therefrom  in  the  shape  of 
trade  discounts,  returns,  allowances,  etc.  The  latter  should  be 
deducted  from  the  gross  income  and  not  be  included  among  the 
expenses.  He  should  then  state  the  expenses  and  costs  as  shown 
by  the  books  and  make  only  such  verification  as  may  be  required. 

Net  Income. — On  the  other  hand,  if  a  prospective  purchaser 
does  not  have  any  preconceived  ideas  as  to  the  proper  relation 
between  gross  and  net  income,  the  auditor  should  make  his 
examination  exhaustive  enough  to  enable  him  to  prepare  and 
submit  full  and  complete  analyses  of  expenses  as  well  as 
earnings. 

The  comparative  statements  of  gross  income  afford  profitable 
data  relating  to  the  progress  of  the  enterprise.  Of  all  businesses 
in  which  a  purchaser  is  interested,  the  one  with  a  stable  earning 
power  and  small  but  sure  net  income  is  preferred  to  the  one  whose 
income  fluctuates  violently.  Many  business  men  manufacturing 
a  novelty,  or  working  under  patents,  have  an  unusually  prosper- 
ous year  due  to  lack  of  competition  or  some  similar  cause.  They 
immediately  talk  of  incorporating  or  reincorporating  on  the  basis 
of  the  one  year's  net  income,  and  commence  to  spend  money  as 
if  it  were  an  annuity  instead  of  the  returns  from  an  exceptional 
year. 

The  auditor  who  is  consulted  in  such  a  case  does  his  client  a 
kindness  if  he  points  out  the  wisdom  of  waiting  until  he  can  show 
a  good  three-  or  five-year  average  before  he  is  justified  in  con- 
sidering his  business  as  on  a  stable  basis,  and  one  in  which  others 
will  care  to  invest.  Fluctuations  must  be  noted  and  explained. 
Gross  income  depends  largely  on  general  business  conditions; 
costs  and  expenses  also  vary. 

It  is  necessary  to  obtain  an  analysis  of  the  accounts  and  be 
able  to  report  the  various  stages  from  gross  income  to  net  income 


440 


AUDITING— GENERAL  PRINCIPLES 


In  a  trading  business,  for  instance,  the  following  form  of  state- 
ment brings  out  the  information  which  a  prospective  purchaser 
requires: 


A.  B.  Company 
Comparative  Income  Statement 
For  three  years  ended 19 . 


Years  Ended 

% 

% 

% 

Gross  Sales 

$ 

$ 

$ 

Less:  Returns  &  Allowances 

Net  Sales 

Inventory,  beginning  of  period 

Purchases,  net 

Less:  Inventory,  end  of  period 

Cost  of  Sales 

Gross  Profit              ....          ... 

Ratio  to  Sales .  .                  ... 

Ratio  to  Cost 

Selling  Expenses: 

Salesmen's  Salaries 

Salesmen's  Expenses 

Commissions 

Advertising 

Catalogues 

Delivery  Expense 

Total  Selling  Expense. 

Ratio  to  Sale? 

Red  ink  should  be  used  when  the  figures  are  not  responsive.  For  example, 
when  expenses  and  costs  exceed  gross  income  and  the  figures  opposite  "net 
income"  are  in  red,  no  further  explanation  is  necessary  to  show  that  the  result 
is  a  deficit  rather  than  net  income. 


INVESTIGATIONS 


441 


Comparative  Income  Statement — Contintied 


Years  Ended 

% 

% 

% 

Administrative  and  General  Expense: 
Executive  Salaries       

$ 

$ 

$ 

Office  Salaries 

Office  Expenses               

Stationery  and  Office  Supplies 

Telephone  &  Telegraph 

Postage 

Traveling  Expenses 

Legal  Expenses             

Rent 

Insurance 

Light,  Heat  and  Power.  .          .... 

Building  Repairs  &  Maintenance . . . 
Depreciation.  ...        

Miscellaneous 

Total  Adm.  &  Gen'l  Expenses...  . 

Ratio  to  Sales 

Total  Expenses. 

Net  Operating  Income 

Other  Income: 

Income  from  Investments . 

Interest  on  Notes  Receivable,  etc.. .  . 

Deductions  from  Income: 

Interest  on  Bonded  Debt 

Interest  on  Notes  Payable 

Total  Deductions.  .  .  . 

Net  Income 

Add  Extraordinary  Credits 

Deduct  Extraordinary  Charges 

Surplus  or  Deficit  for  period 

1 

442  AUDITING— GENERAL  PRINCIPLES 

It  will  be  noted  that  the  ratios  shown  (expressed  in  percent- 
ages) are  gross  income  to  sales,  gross  income  to  cost,  selling  ex- 
penses to  sales,  administration  and  other  expenses  to  sales.  As 
an  investigation  implies  a  comparison  of  two  or  more  years,  these 
percentages  are  of  more  value,  relatively,  than  the  amounts.  The 
net  income  for  each  year  being  shown,  the  next  most  important 
thing  is  to  know  how  it  was  made.  If  the  sales  were  about  the 
same  for  two  successive  years,  the  variations  in  the  percentages 
of  expenses  are  most  interesting,  and  to  a  prospective  purchaser 
it  may  be  a  deciding  factor  to  learn  that  while  the  selling  expenses 
increased,  the  administration  expenses  decreased. 

Verification  of  Sales. — It  is  assumed  that  all  sales  except 
of  recent  date  will  be  verified  otherwise  than  through  the  sales 
records.  That  is,  after  being  charged  to  the  personal  accounts 
of  customers,  if  overdue  they  should  be  handled  as  doubtful 
accounts. 

Since  it  is  customary  to  accept  recent  sales  as  collectible,  it  is 
necessary  for  the  auditor  to  satisfy  himself  that  they  are  bona 
fide  and  not  manipulated  to  produce  a  good  showing  just  before 
the  date  of  the  balance  sheet. 

The  more  common  forms  of  manipulation  are : 

1.  Inclusion  of  goods  sent  on  consignment  and  approval  as 
completed  sales.  This  practice  may  result  from  ignorance, 
rather  than  fraudulent  intent. 

2.  Sales  or  earnings  may  have  been  unduly  inflated  by  charg- 
ing out  wholly  fictitious  quantities  and  amounts.  When  the 
earnings  arise  from  cash  sales,  the  amount  by  which  the  earnings 
are  to  be  increased  is  arbitrarily  added  to  the  daily  receipts.  At 
least  one  instance  is  known  of  the  improper  increase  of  street 
railway  fares  by  a  promoter  who  planned  ahead  to  sell  out.  He 
knew  that  the  purchase  price  would  be  calculated  on  a  certain 
number  of  times  the  net  income  realized,  or  be  based  on  the  gross 
income  of  the  most  recent  period. 

It  will  be  seen  that  if  the  good-will  of  a  property  were  to  be 


INVESTIGATIONS  443 

sold  on  a  basis  of  four  times  the  average  net  earnings  for  the  last 
two  years,  any  method  of  increasing  such  earnings  would  at  least 
double  the  cost  thereof,  i.e.,  the  addition  to  cash  sales  of  each  $ioo 
would  be  divided  by  two  to  get  the  average  for  two  years,  and 
then  multiplied  by  four  to  arrive  at  the  purchase  price,  thus 
yielding  a  profit  of  at  least  loo  per  cent  for  the  fraudulent 
practice. 

A  scheme  of  this  nature  must  necessarily  be  planned  ahead, 
which  does  not  apply  to  most  manipulations.  This  makes  it  ex- 
tremely difficult  to  detect,  and  no  general  test  can  be  devised 
which  will  surely  uncover  the  fraud.  The  auditor  who  keeps 
constantly  before  him  the  possibility  of  fraud  designed  to  inflate 
the  earnings,  has  the  best  chance  of  discovering  it. 

If  the  legitimate  cash  sales  or  receipts  are  small,  no  one  would 
be  bold  enough  to  inflate  them  to  any  considerable  extent. 
Therefore,  the  most  feasible  method  is  to  enter  among  the  bona 
fide  sales  fictitious  names,  quantities,  and  amounts.  This  fraud 
will  be  disclosed  to  the  auditor  who  investigates  the  average 
number  of  new  customers'  accounts  opened  within  a  given  period. 
Any  unusual  increase  is  worth  while  looking  into  in  any  event. 
If  legitimate,  the  question  of  a  continuation  thereof  is  important; 
if  not  legitimate,  it  is  even  more  important  to  uncover  the 
irregularity. 

If  there  has  been  an  increase  in  prices  shortly  before  the  date 
of  the  balance  sheet,  the  cause  thereof  should  be  investigated. 
Such  increases  are  not  always  maintained,  and  it  is  unsafe  to 
depend  thereon  unless  the  most  positive  evidence  can  be  secured 
of  the  propriety  and  wisdom  of  the  change. 

It  may  also  have  been  the  case  that  special  contracts  have 
been  undertaken  which  have  reahzed  large  net  income  but  which 
may  never  be  repeated.  For  instance,  a  small  steam  railway 
company  reaped  the  advantage  of  a  military  encampment  during 
a  considerable  part  of  one  summer.  The  increase  over  its  normal 
traffic  was.  enormous.  Yet  a  prospective  purchaser  has  no 
assurance  whatever  of  a  repetition  of  such  earnings. 


444  AUDITING— GENERAL  PRINCIPLES 

The  period  after  the  closing  date  up  to  the  time  of  the  investi- 
gation must  be  scanned  closely  for  rebates,  allowances,  and 
returns,  to  see  if  they  constitute  deductions  from  prior  sales. 
Likewise,  the  subsequent  sales  should  be  inspected,  particularly 
if  suspiciously  small,  as  this  may  indicate  that  shipments  after 
the  closing  date  were  carried  back  and  charged  under  false  dates. 

It  is  not  sufficient  to  be  informed  that  the  outstandings  have 
been  guaranteed  by  the  vendors,  making  a  valuation  unneces- 
sary. It  may  be  that  fictitious  sales  have  been  entered  in  order 
to  make  a  good  showing,  the  vendors  calculating  that  they  can 
well  afford  to  stand  the  apparent  losses  arising  out  of  the  non- 
collection  of  such  items.  The  auditor  should  keep  this  possi- 
bility in  mind,  and  if  the  vendors  or  guarantors  make  good  any 
considerable  amount  in  this  respect,  the  details  of  the  accounts 
should  be  inquired  into. 

The  Turnover. — Authorities  differ  greatly  as  to  what  this 
term  means.  The  dictionary  definitions  are:  ''A  completed 
commercial  transaction  " ;  *'  The  money  receipts  of  a  business  for  a 
given  period." 

The  merchant  who  speaks  of  his  "turnover"  usually  refers 
to  his  gross  sales,  but  if  his  answer  were  analyzed  it  would  be 
found  that  his  reference  is  rather  to  his  stock  of  goods  than  to  the 
sales  value  thereof.  If  he  starts  his  fiscal  year  with  a  certain 
inventory,  he  endeavors  to  "turn  it  over"  several  times  during 
the  year.  In  this  case  it  means  the  cost  of  the  sales,  because  his 
inventory  and  subsequent  purchases  are  entered  at  cost,  and  it 
is  this  stock  that  he  is  endeavoring  to  turn  over  to  the  greatest 
possible  advantage. 

The  banker  does  not  look  with  favor  on  the  borrower  whose 
gross  sales  are  not  several  times  as  much  as  his  starting  inven- 
tory, and  it  is  a  fair  inference  that  sales  and  cost  of  sales  are  here 
used  interchangeably. 

Uniformity  is  desirable  in  accountancy  terminology,  so  the 
author  suggests  this  definition:  The  turnover  of  a  merchant  or 


INVESTIGATIONS  445 

manufacturer  represents  the  number  of  times  his  capital  in  the 
form  of  stock-in-trade  is  reinvested  in  stock-in-trade  during  a 
given  period. 

To  ascertain  the  turnover,  take  the  starting  inventory,  add 
the  purchases  or  cost  of  manufactured  goods,  and  deduct  the  in- 
ventory at  the  end;  divide  the  total  by  the  starting  inventory. 
The  calculations  are  based  upon  a  normal  inventory.  The  re- 
sult is  the  number  of  times  the  capital  invested  in  stock-in-trade 
has  been  turned  over  during  the  period.  In  the  event  that  the 
value  of  the  inventory  throughout  the  year  varies  considerably, 
or  in  case  of  a  continuous  increase  or  decrease  in  the  volume  of 
business  which  might  have  a  corresponding  effect  on  the  inven- 
tories, a  more  accurate  method  of  determining  the  turnover 
would  be  to  use  the  average  inventory  instead  of  the  starting 
inventory. 

The  capital  invested  in  the  stock  and  the  physical  stock  itself 
may  be  used  synonymously  in  referring  to  the  "turnover"  of  a 
business. 

Profits  on  Fluctuations. — Many  enterprises  using  staple 
raw  materials  frequently  buy  their  requirements  in  advance,  and 
in  numerous  instances  have  found  it  more  profitable  to  sell  their 
entire  stock  on  a  rapidly  advancing  market  than  to  operate  their 
mills.  This  occurs  oftener  with  cotton  than  with  any  other  com- 
modity, but  the  practice  obtains  in  other  lines,  such  as  grain, 
pork,  copper,  etc. 

If  such  profits  are  actually  realized,  they  should  appear  as  a 
special  item  in  the  current  income  account.  If  the  transactions 
have  resulted  in  a  net  loss,  it  also  should  appear  as  a  special  item 
in  the  current  accounts,  inasmuch  as  it  must  be  paid  out  of 
current  net  income. 

Decrease  in  Expenses. — The  expenses  of  all  classes 
should  be  compared  for  a  number  of  years.  If  there  has  been 
any  considerable  decrease  during  the  period  shortly  before  the 
balance   sheet   date,  a  careful    analysis   should    be  made  to 


446  AUDITING— GENERAL  PRINCIPLES 

determine  the  possibility  of  the  omission  of  liabilities  which 
have  been  incurred  but  the  entry  and  payment  thereof  post- 
poned. 

The  auditor  must  look  at  all  expense  payments  after  the 
closing  of  the  books;  if  unduly  large,  the  vouchers  should  be 
examined  and  their  dates  noted,  as  some  of  them  may  be  for 
expenses  incurred  prior  to  the  close  of  the  fiscal  period. 

Advertising  and  Other  Deferred  Charges. — Excessive 
valuations  are  frequently  placed  upon  the  prospective  earning 
power  of  advertising  and  other  forms  of  exploitation.  In  the 
publishing  business,  for  instance,  it  has  been  considered  permis- 
sible to  capitalize  the  expenses  of  establishing  a  magazine.  There 
is  neither  possibility  nor  expectation  of  recouping  the  preliminary 
expenses  out  of  the  earnings  of  the  first  year  or  two.  If  success- 
ful, the  early  advertising,  etc.,  is  justified  and  should  be  charged 
against  the  years  which  reap  the  benefit. 

In  practice,  however,  the  result  is  not  ideal.  Many  periodi- 
cals have  incurred  large  preliminary  expenses,  and  capitalized 
them,  but  have  never  been  able  to  charge  off  any  part  thereof 
against  earnings.  Other  publications  which  have  shown  a  loss 
in  their  early  years  because  no  deferred  charges  were  carried 
over,  have  realized  large  enough  profits  in  subsequent  years  to 
recoup  all  the  preliminary  expenses. 

At  best,  it  is  a  difficult  matter  to  settle  but  it  is  doubly  hard 
for  a  prospective  purchaser.  The  best  advice  to  give  is  to  sug- 
gest that  if  the  business  has  been  running  for  some  time,  all  such 
charges,  unless  very  recent,  should  have  been  absorbed,  and  that 
if  too  recent  to  forecast  the  result,  the  purchase  of  the  prospective 
profits  arising  therefrom  is  a  pure  gamble,  modified  perhaps  by 
evidence,  if  available,  of  what  similar  advertising  expenditure 
has  produced  in  the  past.  An  English  prospectus  contained  the 
certificate  of  a  chartered  accountant  as  to  profits  realized  over  a 
period  of  years  *' before  charging  interest,  management  salaries, 
and  advertising." 


INVESTIGATIONS  447 

Leases. — If  the  concern  under  investigation  does  not  own 
the  land  and  buildings  in  which  its  business  is  transacted,  the 
matter  of  the  lease  and  renewals  thereof  is  of  the  utmost  impor- 
tance. It  is  safe  to  estimate  that  out  of  loo  leases  for  a  long 
term,  or  which  provide  for  extensions,  more  than  75  per  cent 
call  for  a  higher  rental  during  the  later  years  than  at  the  beginning 
of  the  term.  If  the  renewal  rate  is  not  fixed,  it  usually  is  to  be 
based  on  an  appraisal,  and  in  perhaps  every  case  it  is  contem- 
plated by  owner  and  lessee  that  the  future  rental  to  be  fixed  on 
such  appraisal  will  be  higher  as  a  result  thereof. 

Therefore,  the  prospective  purchaser  must  ascertain  definitely 
whether  he  can  retain  the  same  premises  for  a  reasonable  time,  if 
he  so  decides,  and  whether  the  prospects  for  an  increased  busi- 
ness or  other  equivalents  will  compensate  for  the  increased  expense 
if  a  long  lease  is  desired.  Conversely,  a  prospective  purchaser 
may  not  be  willing  to  buy  the  business  unless  it  can  be  removed 
economically  to  a  new  location.  In  such  a  case  a  long  lease  may 
in  itself  prevent  the  consummation  of  the  deal. 

Strange  as  it  may  seem,  prospective  purchasers  do  not  always 
think  of  these  matters  during  the  early  stages  of  negotiations. 
The  auditor  should  ascertain  the  precise  state  of  affairs  with 
respect  to  the  lease  before  he  enters  upon  an  investigation  of 
earnings,  the  result  of  which  would  have  no  interest  for  a  pur- 
chaser who  may  not  otherwise  know  that  a  long  lease  on  an 
ascending  scale  could  not  be  disposed  of. 

In  other  cases,  a  purchaser  may  be  negotiating  for  several 
properties  with  the  intention  of  consolidating  them.  It  may  be 
part  of  his  plans  to  unite  them  all  in  one  place.  Obviously  the 
terms  of  the  leases,  if  any,  are  of  extreme  importance. 

Sometimes  mergers  are  effected,  and  plants  consolidated, 
leaving  certain  plants  idle.  If  the  plans  of  the  promoters  con- 
template leasing  the  idle  plants  at  a  remimerative  rate,  or  leave 
out  of  consideration  the  continuation  of  the  payment  of  rentals 
which  cannot  be  evaded,  a  serious  difference  between  estimated 
and  actual  profits  may  ensue. 


448  AUDITING— GENERAL  PRINCIPLES 

In  conclusion,  it  cannot  be  stated  too  strongly  that  the  loca- 
tion of  a  business  may  determine  its  success  or  failure,  and  any 
facts  or  opinions  relative  thereto  which  the  auditor  can  furnish 
are  of  the  greatest  interest  to  his  client. 

Inventories. — In  an  investigation  for  a  prospective  pur- 
chaser the  question  of  inventories  is  one  of  the  most  important. 
Little  need  be  added  to  the  discussion  of  this  subject  in  Chap- 
ter VIII  and  IX,  except  that  the  distinction  must  be  espe 
cially  noted  between  valuations  properly  incident  to  a  going 
business  and  those  which  apply  in  case  of  the  purchase  of  a 
business. 

Naturally  and  properly,  the  purchaser  wishes  to  buy  as 
cheaply  as  possible,  and  the  seller  desires  to  realize  as  high  a  price 
as  he  can  secure.  But  in  representing  one  or  the  other,  the  audi- 
tor cannot  allow  any  such  considerations  to  afifect  his  mind  in 
arriving  at  the  net  income.  The  latter  should  be  the  same, 
whether  prepared  for  a  vendor  or  a  vendee. 

Inventories  vitally  affect  the  income  account,  and  the  good- 
will of  a  business  rests  upon  the  net  income  realized.  The  result 
is  that  inventories  actually  fix  or  materially  control  the  purchase 
price  of  the  business,  because  the  overstatement  of  an  inventory 
results  in  an  overstatement  of  net  income. 

An  auditor  need  not,  and  as  a  matter  of  fact  he  cannot,  be 
entirely  indifferent  to  the  interests  of  his  client.  If  he  represents 
a  purchaser,  it  is  almost  certain  that  the  seller  has  stated  the  in- 
ventories at  the  highest  possible  price,  so  that  he  need  not  be 
particularly  concerned  about  not  doing  justice  to  him. 

Obviously,  a  purchaser  does  not  wish  to  acquire  "souvenirs" 
illustrative  of  former  unsuccessful  sales  campaigns,  no  matter 
how  willing  the  vendor  may  be  to  part  with  them.  With  this 
thought  in  mind  the  auditor  should  be  able  to  analyze  the 
inventory  for  the  purpose  of  disclosing  unsalable  goods. 

The  experienced  auditor  should  prepare  a  report  the  accuracy 
of  which  he  can  maintain  before  conflicting  interests  if  misunder- 


INVESTIGATIONS  449 

standings  arise,  as  is  often  the  case  when  commercial  enterprises 
change  hands. 

Other  Factors  Which  Affect  Earnings. — Inasmuch  as  all 
of  the  items  of  assets  and  liabilities,  as  well  as  all  sources  of  income 
and  every  class  of  expenses,  enter  into  the  final  adjustment  of  the 
income  account,  the  auditor  should  not  pass  finally  upon  the 
amount  of  net  income  or  deficit,  to  which  he  must  certify,  unless 
he  has  covered,  or  intentionally  left  untouched,  all  of  the  pro- 
cedure required  in  a  balance  sheet  audit.  The  practitioner  who 
does  not  have  his  own  program  for  an  investigation  is  therefore  re- 
ferred to  the  chapters  of  this  book  describing  a  balance  sheet  audit. 

(d)  Future  Requirements  and  Economies 

An  Auditor  Should  Not  Prophesy. — The  author  has  taken 
the  position  that  an  auditor  is  bound  to  furnish  his  client  all  of  the 
information  bearing  on  the  investigation  or  audit  which  he  believes 
to  be  reliable  and  relevant,  and  that  he  is  by  no  means  limited  to 
the  figures  which  any  intelligent  bookkeeper  might  compile. 

But  it  must  be  understood  most  positively  that  it  is  never 
permissible  for  an  auditor,  as  such,  to  certify  to  future  earnings 
or  future  results.  An  auditor  can  express  his  opinion  as  to  the 
effect  particular  transactions  will  have  if  applied  to  a  future  date. 
For  instance,  an  auditor  would  be  justified  in  stating  that  if  a 
minion  dollars  of  bonds  were  sold  at  par,  the  bank  account  would 
be  increased  by  the  same  amount.  But  an  auditor  would  not  be 
justified  in  stating  over  his  signature  that  if  a  million  dollars  of 
bonds  were  sold  at  par  and  invested  in  the  business,  savings  would 
result  sufficient  to  net  additional  net  income.  This  would  be 
pure  surmise,  for  unexpected  losses  or  expe^ises  might  more  than 
offset  the  savings,  or  the  additional  capital  might  be  lost  entirely 
through  errors  of  judgment  in  its  expenditure. 

Business  men  and  financiers  frequently  ask  their  auditors  to 
calculate  the  effect  certain  changes  will  have  on  the  results  of 
operations.     For  instance,  an  auditor  is  asked  to  prepare  a  state- 

VOL.  I — 29 


450  AUDITING— GENERAL  PRINCIPLES 

ment  showing  the  probable  outcome  if  gross  sales  are  doubled, 
with  no  proportionate  increase  in  fixed  charges.  This  is  proper, 
profitable,,  and  pleasing  work  for  a  public  accountant,  and  he 
should  welcome  the  engagement,  but  it  must  be  distinctly  under- 
stood, before  the  work  commences  and  after  it  is  finished,  that 
his  work  is  performed  in  the  capacity  of  an  accountant  and  not 
that  of  an  auditor.  He  should  refrain  from  submitting  his  es- 
timates on  paper  which  bears  his  name  at  the  top  or  the  bottom, 
otherwise  there  is  a  risk  of  the  figures  being  put  forth  as  if  they 
were  certified  to. 

Great  pressure  is  sometimes  brought  to  bear  on  auditors  to 
have  them  certify  to  what  are  in  reality  only  estimates.  It  is  an 
astonishing  fact  that  certificates  have  been  issued  which  are  so 
worded  that  the  untrained  mind  reads  therein  that  the  auditor  is 
satisfied  that  if  certain  additional  capital  is  raised,  or  something 
of  that  kind,  there  will  be  sufficient  earnings  to  pay  a  large  return 
thereon.  The  auditor  who  lends  his  name  to  such  near-fraud 
should  be  expelled  from  any  accounting  body  to  which  he  may 
belong. 

There  are  a  number  of  matters  which  affect  the  future  upon 
which  an  auditor  may  and  should  give  his  opinion,  and  he  may 
and  should  discuss  the  relation  which  such  matters  have  to  the 
past,  but  in  no  case  should  these  be  grouped  in  such  a  way  that 
there  can  be  read  into  the  opinion  a  conclusion  as  to  the  future 
net  income  of  an  enterprise.  The  author  believes  that  this  is 
the  best  test  to  apply  when  in  doubt  as  to  how  far  an  auditor 
should  go  in  furnishing  information. 

Insufficient  Capital. — For  instance,  a  business  may  have 
had  insufficient  working  capital,  and  advantage  may  not  have 
been  taken  of  discounts.  A  prospective  purchaser  may  ask  that 
a  report  be  compiled  which  assumes  adequate  cash  capital.  An 
analysis  of  past  purchases  may  definitely  fix  the  saving  which 
would  have  been  made,  but  the  point  at  issue  is  whether  or  not  a 
like  saving  can  be  realized  in  the  future. 


INVESTIGATIONS  451 

If  an  auditor  is  asked  to  prepare  a  statement  setting  forth  the 
past  results  and  then  stating  that  in  his  opinion  the  following 
period  will  produce  a  given  result,  assuming  the  saving  of  dis- 
counts, he  is  going  far  beyond  his  province.  But  if  in  his  opinion 
the  discounts  will  continue,  or  some  equivalent  thereof,  there  can 
be  no  vahd  objection  to  his  stating  in  a  certificate  that,  assuming 
ample  capital  and  the  same  volume  of  business,  there  will  be  one 
item  of  saving,  mentioning  the  amount. 

There  may  be  other  undue  expenses  or  losses  due  to  insufficient 
capital,  but  most  of  the  arguments  advanced  as  to  what  would 
have  been  accomplished  are  fallacies. 

Naturally  a  prospective  purchaser  wants  to  know  wherein 
economies  can  be  effected  or  net  income  increased,  and  evidence 
may  be  available  to  prove  the  truth  of  the  representations  made. 
The  most  common  claim  is  that  the  output  has  been  too  small, 
and  that  additional  facilities  would  have  meant  greatly  increased 
net  income.  Output,  however,  must  be  sold  to  produce  a  profit, 
and  it  is  always  easier  to  talk  about  a  big  increase  in  sales  than 
to  secure  actual  orders.  Men  who  are  partially  successful  fre- 
quently overestimate  the  buying  capacity  for  what  they  sell. 
The  market  may  readily  consume  all  that  is  offered,  but  if  the 
offerings  were  to  double,  the  sales  price  of  the  whole  might  be 
reduced  to  an  unprofitable  basis. 

Large  capital  is  by  no  means  a  guarantee  of  financial  success, 
and  any  investigation  into  the  capital  required  for  a  particular 
business,  the  effect  of  a  lack  of  it  in  the  past,  and  the  possible 
returns  therefrom  in  the  future,  calls  for  more  acumen  and 
general  business  knowledge  than  most  men  possess.  Neverthe- 
less, there  are  times  when  an  auditor  can  be  of  substantial  aid 
in  such  an  investigation,  and  there  can  be  no  objection  to  his 
placing  at  the  disposal  of  his  client  the  benefit  of  his  experience; 
but  for  his  own  sake  he  must  not  permit  the  pubhcation  of  a 
certificate  which  can  be  directly  or  mdirectly  interpreted  as  a 
statement  of  future  results. 

Comments  on  future  requirements  should  always  be  accom- 


452  AUDITING— GENERAL  PRINCIPLES 

panied  by  a  statement  of  the  average  net  capital  employed  in 
the  old  business.  This  affords  an  opportunity  for  a  prospective 
purchaser  to  arrange  for  additional  capital  if  the  old  is  inadequate. 

Economies  Exaggerated. — One  has  but  to  read  some  of  the 
glowing  prospectuses  issued  during  19 19  and  1920  to  appreciate 
the  difference  between  expectation  and  realization.  Fortu- 
nately, not  much  of  the  responsibility  for  the  failure  of  many 
large  enterprises  can  be  traced  to  auditors,  but  a  part  of  the 
blame  sometimes  rests  on  their  shoulders. 

It  has  been  stated  in  these  pages  that  an  accountant  should 
be  available  to  make  calculations  and  compile  data,  for  which 
others  must  take  the  responsibility.  This  is  true,  but  no  public 
accountant  should  ever  work  in  the  capacity  of  a  clerk.  He  may 
assist  in  the  preparation  of  a  statement  which  purports  to  show 
the  economies  to  be  effected  by  a  merger  of  two  or  more  concerns, 
but  if,  through  ignorance  or  lack  of  experience,  estimates  are 
made  which  the  accountant  knows  cannot  be  fulfilled,  he  should 
not  hesitate  to  express  his  convictions,  and  if  it  appears  that  facts 
are  to  be  ignored  and  the  public  deceived,  he  should  withdraw  in 
order  to  avoid  any  possible  connection  with  the  enterprise. 

Almost  without  exception  promoters  have,  or  seem  to  have, 
visions  of  two  or  more  plants  being  conducted  on  about  the  same 
expense  ratio  as  the  most  economical  of  those  merged.  Econo- 
mies in  all  departments  are  prophesied,  and  as  a  matter  of  fact 
many  are  possible  and  are  effected.  But  they  are  sorely  needed 
to  offset  the  extraordinary  expenses  and  extravagances  which 
seem  to  be  a  necessary  element  in  the  promotion  and  establish- 
ment of  all  such  consolidations. 

To  start  with,  vast  sums  are  paid  in  cash  or  securities  to 
promoters,  attorneys,  and  insiders.  Then  engineers  and  account- 
ants must  receive  large  fees,  although  far  less  in  proportion  than 
those  paid  the  lawyers. 

The  bankers,  lawyers,  and  others  who  become  members  of 
the  board  would  not  think  of  attending  a  board  meeting  at  the 


INVESTIGATIONS  453 

dingy  business  offices  of  one  of  the  old  concerns,  so  a  large  and 
expensive  suite  of  offices  is  secured  ''downtown."  With  expensive 
offices  go  expensive  clerks,  and  so  on  down  the  line.  How  many 
poorly  paid  clerks  and  others  must  be  dismissed  at  the  works 
to  pay  a  fractional  part  of  the  new  and  additional  expenses  which 
were  not  referred  to  in  the  prospectus? 

If  anyone  thinks  this  description  is  an  exaggeration,  let  him 
examine  the  literature  and  subsequent  record  of  a  few  of  the 
popular  consolidations. 

Former  Owners'  Attitude. — Except  in  rare  cases,  the  busi- 
ness which  changes  hands  or  consolidates  with  others  has  been 
prosperous.  It  is  conceded  that  the  personal  element  is  the  most 
important  factor  in  business  life,  so  that  if  the  personal  attention 
of  the  former  proprietor  is  not  available  after  the  sale  takes  place, 
it  is  absolutely  essential  that  an  equivalent  be  found,  or  the 
success  of  former  years  will  not  be  duplicated. 

This  is  another  of  the  matters  with  which  an  auditor  is  not 
usually  concerned,  but  no  one  has  a  better  opportunity  to  observe 
the  relative  position  of  each  person  responsible  for  the  former 
prosperity  than  the  auditor  who  investigates  the  finances  of  the 
business  for  a  series  of  years.  If  the  examination  makes  it  appar- 
ent that  one  or  more  of  the  proprietors,  managers,  or  other 
officials  were  dominant  in  its  affairs,  there  can  be  no  reasonable 
objection  to  this  fact  being  communicated  to  the  prospective 
purchaser. 

Many  men  think  that  ordinary  ability,  coupled  with  plenty 
of  money,  can  win  success  in  almost  any  line  of  business,  but  this 
is  not  true,  as  may  be  proved  beyond  a  doubt  by  examining  for  a 
while  the  bankruptcy  announcements.  Many  concerns  which 
start  in  business  with  ample  capital  fail  because  they  are  not 
properly  managed.  Other  concerns  with  less  capital,  doing  pre- 
cisely the  same  kind  of  business,  during  the  same  period  of  time, 
realize  large  profits. 

One  of  the  most  striking  instances  is  that  of  the  wholesale 


454  AUDITING— GENERAL  PRINCIPLES 

grocery  business.  Here  conditions  are  nearly  equal.  The  same 
kinds  of  goods  are  bought  and  sold.  The  same  customers  are 
available  to  all,  yet  in  the  same  city  one  concern  earns  large  net 
income,  while  another  doing  a  large  business  does  not  earn  a 
dollar  of  net  income.  It  is  due  to  the  personnel  of  the  man- 
agement, and,  where  successful  executives  can  be  retained, 
an  auditor  is  not  exceeding  his  duty  if  he  comments  on  the 
matter. 

Competition. — Some  business  men  wish  to  expand,  or  con- 
solidate, or  do  something  else  that  sounds  big  just  as  soon  as  they 
have  had  one  big  year.  It  usually  happens  that  the  extraordi- 
nary income  earned  has  been  due  to  a  monopoly  of  a  certain  kind 
of  product.  Now  economic  laws  adjust  an  inordinate  profit  by 
stimulating  competition.  Publicity  which  follows  a  sale  or  the 
publication  of  results  will,  of  course,  spread  the  knowledge  of 
large  net  income. 

An  exception  may  be  noted  in  the  case  of  patented  articles, 
where  the  continuance  of  a  monopoly  is  protected  by  law.  But 
where  there  are  no  patents  of  vital  importance,  the  question  of 
competition  must  be  seriously  considered. 

Another  element  which  affects  competition  is  the  personal 
attention  referred  to  in  the  preceding  section.  If  the  business 
deals  in  any  goods  which  are  dependent  upon  the  taste  of  the 
pubHc,  it  must  be  borne  in  mind  that  the  public  is  very  fickle. 
Popular  demand  may  be  increased  by  advertising  or  maintained 
more  or  less  by  fair  dealing  and  courteous  treatment,  but  no  one 
can  foretell  what  the  future  will  develop  in  the  way  of  competition. 
For  this  reason  a  prospective  purchaser  must  think  deeply  before 
he  commits  himself  to  a  proposition,  which,  to  yield  a  satisfac- 
tory return  upon  the  purchase  price,  must  continue  to  earn  such 
a  large  gross  income  that  an  endeavor  is  made  to  keep  the  facts 
secret. 

How  long  the  operation  of  an  economic  law  can  be  suspended 
is  for  the  purchaser  to  decide. 


INVESTIGATIONS  455 

(e)  System  of  Accounts 

Criticisms  Should  Be  Postponed. — In  special  investiga- 
tions such  as  are  here  discussed,  the  auditor  should  never  express 
an  opinion  as  to  the  condition  of  the  accounts,  except  in  a  con- 
fidential report  to  the  prospective  purchaser.  During  the  course 
of  the  work  he  must  accept  things  as  he  finds  them,  and,  in  order 
to  secure  the  sympathy  or  co-operation  of  the  office  staff,  he  must 
be  careful  to  praise  anything  which  deserves  praise,  and  refrain 
as  much  as  possible  from  criticizing  accounts  or  methods  which 
cannot  be  approved. 

When  the  purchase  is  consummated  and  the  auditor  is  re- 
quested to  submit  suggestions  and  criticisms,  then  his  working 
papers  should  disclose  full  information  available  for  use. 

Condition  of  Accounts  an  Index  to  Proprietors. — There 
are  some  particularly  shrewd  bankers  who  make  frequent  pur- 
chases of  properties  and  in  other  cases  furnish  capital,  who  con- 
sider that  an  auditor's  report  on  the  condition  of  the  accounts 
reflects  very  accurately  the  kind  of  men  who  have  been  ruiming 
the  business. 

If  net  income  has  been  large  and  no  accounts  worthy  of  the 
name  have  been  kept,  it  is  apparent  that  these  men  have  de- 
pended upon  their  own  ability  to  earn  money,  and,  since  this 
cannot  be  sold  and  transferred  very  readily,  it  is  not  a  safe  plan 
to  continue  such  incomplete  records. 

Preparation  for  New  System. — Therefore,  in  their  con- 
tracts the  bankers  sometimes  insert  stipulations  along  the 
following  lines : 

I.  That  within  sixty  days  after  the  formation  of  the  new 
company,  public  accountants  satisfactory  to  the  purchasers  shall 
be  employed  to  devise  and  install  a  modem  system  of  accounts 
for  the  company  which  will  permit  of  full  and  accurate  reports  of 
its  operations  and  its  financial  condition  being  made  at  least 
monthly.  (In  many  cases  this  provision  is  objected  to,  but 
bankers  are  anxious  to  have  the  accounts  reorganized  wherever 


456  AUDITING— GENERAL  PRINCIPLES 

dependable  results  are  not  readily  available,  and  therefore  hesi- 
tate to  finance  a  company  whose  accounts  are  unsatisfactory.) 

2.  That  said  accountants  shall  be  furnished  all  requisite  in- 
formation and  facilities  for  carrying  into  effect  such  changes  as 
may  be  necessary,  and  that  the  officers  and  employees  of  said  new 
company  shall  co-operate  with  the  accountants  in  the  installa- 
tion and  completion  of  the  new  system  within  a  reasonable  time, 
which  in  no  event  shall  exceed  twelve  months  from  the  date 
hereof. 

3.  That  the  reports  contemplated  by  said  proposed  new  sys- 
tem shall  be  delivered  each  month  to  the  board  of  directors  of 
the  new  company,  one  copy  thereof  to  remain  on  file  with  the 
secretary  of  the  company,  subject  to  the  inspection  of  any 
member  of  the  board,  and  one  copy  thereof  to  be  mailed  each 
month  to  the  purchasers,  as  long  as  the  (preferred)  stock  is  not 
retired. 

4.  That  in  the  event  of  accountants  being  employed  for  the 
purposes  heretofore  stated,  then  the  said  accountants  shall  be 
retained  to  audit  the  accounts  of  the  new  company  at  least  an- 
nually. If  the  system  in  use  is  satisfactory  and  accountants  are 
not  required  immediately,  they  shall  in  any  event  be  retained  to 
audit  the  accounts  at  least  annually;  copies  of  their  report  to  be 
delivered  and  filed  as  set  forth  in  paragraph  3. 

5.  If  vendors  do  not  name  accountants  satisfactory  to  pur- 
chasers, the  latter  may  nominate  and  the  vendors  agree  to  employ 
accountants  so  nominated  and  to  carry  out  the  provisions  refer- 
ring to  accountants  with  the  same  effect  as  if  said  accountants 
were  appointed  by  the  vendors. 

(f )  Elimination  of  Unusual  Items 

It  is  a  dangerous  practice  to  eliminate  items  solely  because 
they  appear  to  be  extraordinary.  It  is  safe  to  say  that 
no  business  has  ever  been  free  from  unexpected  losses  and  expen- 
ses. Nevertheless  the  auditor  is  expected  to  state  separately  all 
important  items  which  on  their  face  are  extraordinary. 


INVESTIGATIONS  457 

Earnings. — A  purchaser  profits  from  future  business  only. 
Large  special  earnings  may  have  been  made  in  the  past,  but  his 
interest  lies  in  the  possible  net  income  of  the  future.  Necessarily 
this  is  based  largely  on  past  experience,  but  if  there  are  items 
which  probably  will  not  appear  under  subsequent  conditions,  they 
must  be  eliminated  from  that  part  of  the  report  upon  which  his 
opinion  whether  or  not  to  buy  will  be  formed. 

Income  from  Assets  Not  Taken  Over. — The  auditor,  in  order 
to  make  an  intelligent  report,  must  have  a  copy  of  the  purchase 
contract  or  option.  In  many  cases  there  are  items  which  appear 
on  the  books  which  are  not  included  in  the  purchase  price  and 
which  are  to  be  retained  by  the  vendor.  It  is  important  to  ascer- 
tain whether  any  income  from  assets  of  this  nature  has  been  in- 
cluded in  the  current  earnings. 

Interest  on  Deposits. — If  the  bank  balances  have  been  nor- 
mal, any  interest  thereon  should  not  be  eliminated  unless  it  is  known 
that  the  future  bank  accounts  are  not  to  bear  interest.  Some  firms 
carry  many  hundreds  of  thousands  of  dollars  on  deposit  all  the 
time,  earning,  perhaps,  2  or  2}^  per  cent,  just  because  they  always 
want  to  be  ready  for  an  emergency.  It  is  not  likely  that  anyone 
buying  such  a  business  contemplates  the  same  practice. 

Sale  of  Assets. — The  analysis  of  earnings  discloses  whether 
anything  has  been  included  which  represents  profit  on  the  sale  of 
a  portion  of  the  capital  assets.  For  instance,  an  old  building  or 
some  land  may  be  sold  at  an  advance  over  the  book  value.  This 
is  clearly  an  extraordinary  profit  and  must  not  be  included  among 
the  earnings. 

The  author  was  called  upon  to  verify  the  earnings  of  a  concern 
and  found  that  among  the  current  earnings  were  profits  on  the 
purchase  and  sale  of  the  company's  own  preferred  stock. 

Appreciation  of  Assets. — It  is  a  common  error  to  assume 
that  an  appreciation  in  the  value  of  land  or  any  other  fixed  asset 
can  offset  the  depreciation  of  plant. 


458  AUDITING— GENERAL  PRINCIPLES 

If  a  statement  of  earnings  has  been  prepared  from  the  books, 
and  an  appraisal  shows  that  the  assets  are  equal  to  the  book 
value,  but  that  the  land  has  appreciated  in  value  $100,000  while 
the  machinery  has  depreciated  $100,000,  then  the  amount  of 
appreciation  must  be  eliminated  and  treated  as  extraordinary 
income,  and  the  depreciation  included  among  the  expenses  and 
deducted  from  income. 

Insurance  Profit. — If  a  fire  has  occurred,  it  may  be  found 
that  the  books  show  that  a  profit  has  been  realized.  This  usually 
occurs  where  book  values  have  been  written  down  to  be  conserv- 
ative, but  the  insurance  has  been  left  undisturbed.  As  the 
assured  is  entitled  to  recover  the  sound  or  replaceable  value  of  his 
property,  he  may  be  collecting  for  obsolete  or  abandoned  machin- 
ery, etc.  In  such  case,  since  the  prospective  purchaser,  in  order 
to  be  conservative,  will  follow  the  same  system  of  charging  off, 
and  cannot  depend  on  a  fire,  the  apparent  profit  cannot  be 
included  among  the  current  earnings. 

Damages  for  Change  of  Grade,  etc. — Other  extraordinary 
receipts  may  arise  out  of  damages  collected  from  compulsory 
change  of  grade,  a  portion  of  the  premises  being  condemned  for 
municipal  or  public  utility  use,  etc.  These  are  all  unusual  items 
and  are  not  apt  to  recur  in  the  same  business,  so  they  cannot  be 
included  among  current  earnings. 

Expenses. — There  may  have  been  special  losses  or  expenses 
which  the  prospective  purchaser  can,  or  thinks  he  can,  avoid. 
These,  too,  must  be  separately  stated. 

Excessive  Reserves. — Just  as  some  men  decline  to  allow  for 
known  losses,  such  as  bad  debts,  depreciation,  etc.,  others  insist 
on  writing  off  all  of  their  furniture  and  fixtures  and  create  exces- 
sive reserves  for  other  wasting  assets. 

Since  the  passage  of  the  federal  income  tax  law,  some  corpo- 
rations have  entered  excessive  depreciation  in  their  books.  Upon 
a  sale  they  would  hardly  admit  that  such  charges  were  proper 


INVESTIGATIONS  459 

deductions  from  income,  and  if  the  auditor  finds  that  they  are 
excessive,  he  will  adjust  the  accounts  accordingly. 

The  auditor  should  endeavor  to  have  the  reserves  represent 
actual  depreciation  or  prospective  losses.  When  they  go  beyond 
this  they  are  in  reality  part  of  the  surplus  and  are  to  be  so  treated. 

Embezzlements. — It  is  to  be  assumed  that  a  prospective 
purchaser,  wise  enough  to  employ  a  professional  auditor  to 
investigate  the  business  he  expects  to  buy,  will,  if  he  acquires  the 
business,  bond  all  employees  and  have  the  accounts  audited 
periodically  thereafter,  so  that  any  past  loss  through  embezzle- 
ment can  be  eliminated  from  the  expenses. 

Auditors  should  impress  upon  new  executives  the  value  of 
surety  bonds  for  all  employees.  Many  employers  who  have 
postponed  action  for  many  years  never  do  get  around  to  it,  but  a 
new  proprietor  can  insist  on  this  matter  without  offending  any 
sensitive  employee.  Failure  to  observe  this  precaution  has 
entailed  enormous  losses  to  some  concerns. 

Fire  and  Other  Losses  Not  Insured. — Likewise,  the  pur- 
chaser should  carry  an  ample  line  of  all  kinds  of  insurance,  so 
that  if  there  has  been  a  fire  loss  not  fully  covered,  or  if  an 
employee  has  been  injured  and  no  liability  insurance  has  been 
carried,  or  if  plate  glass  windows  be  broken,  etc.,  the  losses 
so  sustained  can  be  eliminated  from  the  current  expenses — which 
should  include,  however,  a  sum  equal  to  the  premiums  on  such 
insurance  as  if  it  had  been  carried. 

Another  form  of  protection  which  prudent  business  men  carry 
is  ''profit"  insurance.  This  covers  loss  of  the  estimated  profit 
which  might  have  been  earned  had  no  fire  occurred.  The  rate  is 
about  the  same  as  for  fire  insurance,  which  in  most  manufacturing 
plants  is  extremely  low. 

It  cannot  be  held,  however,  that  an  auditor  can  certify  that 
the  earnings  of  a  certain  business  would  have  been  a  given  sum 
if  a  fire  had  not  occurred.  If  profit  insurance  had  been  carried, 
and  the  face  of  the  policies  collected,  there  could  be  no  objection 


46o  AUDITING— GENERAL  PRINCIPLES 

to  stating  the  source  of  such  receipts,  but  even  then  it  is  question- 
able if  an  auditor  should  include  the  income  so  derived  among 
current  earnings.  If  all  of  the  unavoidable  expenses  incurred 
during  the  time  the  plant  is  not  in  operation  are  taken  into 
consideration,  there  is  no  great  objection  to  including  the  pro- 
ceeds of  insurance  among  current  earnings,  but  the  item  is  not 
a  usual  one  and  for  comparative  purposes  cannot  be  regarded  as 
normal. 

Actions  at  Law. — Where  any  considerable  expenditure  has 
been  made  by  reason  of  a  verdict  or  compromise  arising  out  of  a 
suit  on  contract  or  infringement,  etc.,  it  may  be  that  part  of  such 
payment  is  properly  included  among  the  current  expenses,  but 
that  a  part  is  applicable  to  prior  periods.  The  auditor  must  deal 
with  such  items  on  their  own  merits. 

(g)  Adjustments  and  Qualifications 

Partners'  Salaries. — In  stating  the  accounts  of  a  business 
in  connection  with  a  sale,  it  is  customary  to  eliminate  from  the 
expenses  the  amount  charged  on  the  books  as  partners'  salaries. 
This  may  be  misleading,  particularly  when  the  earnings  are 
shown  in  support  of  an  issue  of  bonds  or  preferred  stock.  For 
instance,  the  statement  may  be  made  that  the  net  earnings  of  a 
partnership  have  averaged  $48,000  per  annum,  this  being  four 
times  the  interest  on  an  issue  of  $200,000  6  per  cent  preferred 
stock.  In  arriving  at  the  net  profit,  custom  decrees  that  the  part- 
ners' compensation  may  be  omitted.  It  is  true  that,  imless 
mention  is  made  of  the  amount,  it  is  difficult  for  anyone  without  a 
knowledge  of  the  facts  to  form  an  opinion  on  the  matter.  Part- 
ners frequently  pay  themselves  large  periodical  sums  carried  on 
the  books  as  salaries.  Many  others  credit  themselves  with  about 
the  equivalent  of  the  salary  of  a  manager  or  a  good  salesman, 
while  in  many  cases  no  salary  at  all  is  allowed  for. 

In  the  case  mentioned  it  may  be  expected  that  after  the 
corporation  is  formed,  the  officers  (former  partners)  will  insist  on 


INVESTIGATIONS  461 

salaries  unless  they  have  stipulated  that  none  will  be  voted  or 
drawn.  Such  stipulation  is  rare,  so  that  it  is  not  unusual  in  a 
corporation  of  this  size  for  salaries  of  $15,000  to  $25,000  to  be 
voted  to  the  new  officers.  This  becomes  a  charge  to  income,  and 
thereby  reduces  the  amount  available  for  dividends  on  the  pre- 
ferred stock.  In  other  words,  the  future  net  income  will  be 
largely  diminished,  perhaps  half,  through  the  change  of  name 
from  ''partners'  withdrawals"  (not  an  expense)  to  "officers' 
salaries  "  (an  expense) .  Therefore  a  charge  should  be  inserted  for 
management  salaries.  In  cases  of  financing  there  is  frequently 
some  contract  provision  fixing  the  amount  so  to  be  paid.  In  any 
event  an  intelHgent  estimate  can  and  should  be  made. 

An  auditor  is  never  justified  in  signing  a  certificate  omitting 
partners'  compensation,  unless  the  fact  is  clearly  stated,  and  any 
reference  to  the  bearing  past  net  income  has  on  a  bond  or  stock 
issue  is  qualified  by  this  omission. 

Contracts. — If  a  business  is  of  such  a  nature  that  contracts 
for  purchases  or  sales  to  be  received  or  deHvered  in  the  future  are 
the  custom,  it  is  not  sufficient  to  stop  with  the  results  of  the  last 
fiscal  period  unless  the  effect  of  the  contracts  outstanding  at  that 
time  be  considered. 

For  instance,  contracts  may  have  been  entered  into  for 
raw  materials  at  a  high  figure,  and  at  the  time  of  the  examination 
the  market  may  be  much  lower.  During  recent  years  good 
accounting  practice  has  demanded  that  reserves  be  set  up  for  the 
accrued  losses  when  the  amount  is  determinable;  when  this  is  not 
feasible  the  estimated  amount  of  the  loss  should  be  shown  as  a 
memorandum  on  the  face  of  the  balance  sheet. 

If  the  contracts  cannot  be  canceled,  with  the  consequence 
that  the  new  period  is  saddled  with  the  necessity  of  buying 
materials  at  an  inflated  price,  the  auditor  must  adjust  the 
accounts  accordingly.  It  may  be  that  the  prospective  purchaser 
has  full  knowledge  of  the  unfavorable  agreements,  but  the  auditor 
must  not  assume  this.     If  it  is  stated  that  unfavorable  contracts 


462  AUDITING— GENERAL  PRINCIPLES 

for  purchases  or  sales  can  be  canceled,  something  more  than  the 
word  of  an  interested  party  should  be  necessary  to  convince 
the  auditor. 

Taxes. — While  considering  adjustments,  the  subject  of  taxes 
must  be  considered.  It  is  becoming  popular  to  levy  taxes  on 
whatever  person  or  thing  will  stand  it.  In  many  localities  real 
estate  taxes  are  increasing  steadily  from  year  to  year.  At  the 
time  of  the  examination,  if  an  assessment  has  been  made  for  the 
following  year,  the  auditor  should  inspect  it  and  compare  the 
amount  payable  thereunder  with  the  previous  year.  As  there 
may  be  an  increase  in  the  valuation  as  well  as  the  rate,  the 
increased  taxes  may  be  a  sufficiently  large  factor  to  force  a  some- 
what lower  price  from  the  seller. 

Royalties. — Where  royalties  have  been  paid  under  a  license, 
and  the  financing  provides  for  the  purchase  of  the  patents  or 
copyrights,  it  may  be  permissible  to  eliminate  from  expenses  the 
amounts  paid  in  the  past,  so  far  as  the  possibilities  of  the  future 
are  concerned.  But  it  may  be  unsafe  to  make  the  adjustment 
unless  every  detail  of  the  acquisition  of  the  patents  is  available 
and  it  is  found  that  a  clear  saving  will  result.  Verbal  statements 
of  this  nature,  relied  on  by  auditors,  have  led  to  unfortunate 
experiences  in  the  past. 

The  adjustment  must  include  a  periodical  allowance  for  the 
extinguishment  of  the  price  paid  for  the  patent  or  copyright. 

The  capitalization,  or  proposed  capitalization,  in  case  of 
a  purchase  must  not  be  confused  with  the  treatment  of  royalties 
in  the  income  account.  Royalties  paid  constitute  an  expense, 
and  royalties  received  represent  income.  In  the  former  case  it  is 
assumed  that  the  patents  (if  it  is  out  of  patents  that  the  royalties 
arise)  are  not  owned,  and  in  the  latter  case  that  they  are  owned. 
If  the  patents  are  owned,  the  only  income  which  can  arise  directly 
therefrom  is  from  outsiders.  The  concern  itself  receives  an 
equivalent  in  the  form  of  reduced  expenses  by  reason  of  not 
having  to  pay  for  the  use  of  the  patent. 


INVESTIGATIONS  4^3 

Orders  of  Public  Service  Commissions. — In  making  investi- 
gations of  public  service  corporations  operating  in  the  jurisdic- 
tion of  a  public  service  commission,  the  auditor  should  not  fail 
to  make  a  thorough  inquiry  into  the  question  of  whether  any 
orders  issued  by  the  commission  have  not  been  complied  with 
by  the  corporation  whose  accounts  are  the  subject  of  examina- 
tion. Compliance  with  such  orders  may  require  the  expenditure 
of  considerable  sums  of  money — perhaps  for  purposes  which  will 
not  result  in  a  corresponding  increase  of  revenue;  instead  of  an 
increase  in  revenue,  there  may  be  only  an  increased  expense  for 
maintaining  or  operating  appliances  required  to  be  installed.  If 
the  prospective  purchaser  has  knowledge  of  the  matter,  he  is  in  a 
position  to  protect  himself  when  conducting  negotiations  with  the 
seller.  In  the  absence  of  such  knowledge,  however,  he  receives  a 
severe  shock  on  being  required,  after  concluding  the  purchase,  to 
make  the  entirely  unexpected  expenditures  necessitated  by  the 
orders  issued  before  his  coming  into  possession  of  the  property. 

(h)  Errors  in  the  Books 

As  heretofore  stated,  an  investigation  is  an  audit  for  a  special 
purpose.  If  the  special  purpose  is  the  location  of  errors,  then  the 
auditor  should  proceed  as  in  a  regular  audit  and  nothing  addi- 
tional need  be  said.  But  in  other  classes  of  investigations,  the 
question  frequently  arises  as  to  how  far  the  auditor  should, 
or  must,  go  in  order  to  satisfy  himself  that  the  accounts  are 
correct. 

For  instance,  in  an  inquiry  into  earnings,  it  is  necessary  that 
he  should  be  satisfied  that  the  income  is  at  least  as  much  as  the 
aggregate  to  which  he  certifies.  But  suppose  part  of  the  income 
which  should  have  been  included  has  never  been  carried  into  the 
books,  having  been  misappropriated,  or  lost  through  carelessness 
or  neglect? 

As  to  this,  the  opinions  of  professional  accountants  differ. 
Some  say  that  in  investigating  the  net  income  of  a  business  with 
reference  to  a  sale,  an  accountant  is  not  expected  to  check  the 


464  AUDITING— GENERAL  PRINCIPLES 

books  and  entries  for  the  purpose  of  detecting  falsifications,  there 
being  a  marked  difference  between  an  audit  and  an  investigation 
with  a  view  to  profits,  that  some  defalcations  could  not  be  dis- 
covered without  verifying  footings,  postings,  and  vouchers,  and 
that  cKents  do  not  desire,  and  are  unwilling  to  pay  for,  a  detailed 
audit.  On  the  other  hand,  it  is  contended  that  an  auditor  is  not 
justified  in  certifying  to  a  balance  sheet  and  income  account 
unless  an  audit  has  been  made. 

Tests  Required. — In  the  author's  opinion,  the  test  of  what 
should  be  done  depends  upon  the  nature  of  the  result  to  be 
attained.  If  an  auditor  is  requested  to  examine  the  accounts 
of  a  business  for  a  period  of  years,  to  state  and  certify  to  the  net 
income  realized  and  to  the  financial  condition  as  of  a  certain  date, 
then  it  is  proper  to  restrict  oneself  to  the  actual  work  necessary, 
and  additional  work  is  superfluous.  If  income  or  assets  have 
been  omitted,  and  the  omission  cannot  be  detected  unless  a  com- 
plete audit  is  made,  nevertheless  the  auditor  has  fulfilled  his 
duty.  If  expenses  or  liabilities  have  been  omitted,  the  auditor 
cannot  be  excused  even  if  a  detailed  audit  is  necessary  to  discover 
the  omissions. 

No  examination  along  the  lines  indicated  can  be  considered 
as  complete  in  any  event  unless  intelligent  analyses  are  made 
of  the  various  income  and  expense  accounts.  These  analyses 
may  disclose  fraud  or  errors  of  principle  if  they  exist. 

The  Final  Test. — The  final  test  of  the  sufficiency  of  the 
examination  lies  in  the  skill  with  which  the  work  is  handled. 
If  the  auditor  brings  to  bear  all  of  the  care  and  skill  which  may 
reasonably  be  demanded  of  an  experienced  practitioner,  then  he 
cannot  be  held  morally  or  professionally  responsible  for  well- 
concealed  errors  or  omissions,  but  it  must  be  remembered  that  the 
degree  of  care  and  skill  called  for  is  much  greater  than  is  expected 
or  legally  demanded  from  an  inexperienced  person  or  one  who 
does  not  hold  himself  out  as  a  professional  auditor. 


INVESTIGATIONS  4^5 

(i)  Investigation  on  Behalf  of  a  Retiring  Partner  When  the 
Business  Is  Being  Sold  to  a  Continuing  Partner 

When  the  retirement  of  a  partner  is  caused  by  his  death  or  by- 
physical  disability,  a  *' continuing"  partner  may  also  be  a  ''liqui- 
dating" partner.  In  such  case  the  continuing  partner  is  charged 
with  a  greater  degree  of  responsibility  than  that  to  which  the 
purchaser  of  a  business  under  other  circumstances  is  held.  The 
continuing  partner  is  in  the  best  position  to  protect  his  own 
interests,  and  the  auditor's  connection  with  the  liquidation  of  the 
old  firm  will  most  frequently  be  as  representative  of  the  retiring 
partner. 

Special  Conditions. — The  auditor  should  do  all  the  work 
which  is  usually  included  in  an  investigation  made  for  an  intend- 
ing purchaser,  but  there  are,  in  addition,  certain  other  phases 
of  the  situation  which  should  receive  consideration,  and  it  is  these 
of  which  mention  will  be  made.  It  is  only  equitable  that  the 
assets  should  be  valued  on  the  basis  of  a  going  concern,  and  it  is 
clearly  the  duty  of  the  auditor  to  see  that  they  are  not  under- 
valued. It  is  most  satisfactory  to  have  independent  appraisers 
employed  to  value  such  assets  as  plant  and  stock-in-trade,  due 
consideration  being  given  both  to  the  circumstances  of  the  case 
and  the  rights  of  each  of  the  partners.  Frequently,  however,  this 
is  not  done,  and  the  business  is  liquidated  by  the  continuing 
partner,  who  himself  values  the  various  assets.  While  specific 
rules  to  be  followed  can  hardly  be  laid  down,  it  should  be  observed 
that  in  cases  of  doubt  as  to  values  the  absent  partner  should  have 
the  benefit  thereof.  This  is  only  fair  because  the  surviving  or 
continuing  partner  is  in  a  position  to  secure  what  he  believes  to  be 
his  rights,  whereas  the  retiring  partner,  through  death  or  absence, 
is  not  in  the  same  position  to  urge  the  consideration  of  his  rights. 
It  is  an  estabhshed  rule  of  law  that  a  liquidating  partner  must  not 
take  advantage  of  his  position,  and  this  of  itself  is  sufficient  rea- 
son for  his  deciding  all  doubtful  cases  in  favor  of  the  absent 
partner. 

VOL.  I — 30 


466  AUDITING— GENERAL  PRINCIPLES 

Accounts  Receivable,  etc. — Accounts  receivable  and  any 
other  choses  in  action  should  be  ''worked  out."  The  continuing 
partner  is  not  entitled  to  any  commission  for  his  own  services  in 
this  connection,  though  he  should  be  reimbursed  for  the  actual 
expenses  incurred  for  clerical  work  entailed  thereby.  Discounts 
and  other  allowances  credited  to  customers  upon  settlement  of 
the  outstanding  accounts  should  be  carefully  scrutinized.  Goods 
returned  by  customers  subsequent  to  the  date  of  dissolution  are 
ordinarily  taken  into  the  stock  of  the  new  business,  and,  unless 
particular  attention  is  given  to  this  class  of  transactions,  the 
charge  which  should  be  made  to  the  new  business  and  credited  to 
the  liquidation  of  the  old  may  very  easily  be  overlooked.  Unless 
the  total  amount  involved  is  very  small  indeed,  all  credits  to  old 
customers  other  than  for  cash  should  be  analyzed.  Those  which 
are  for  goods  returned  can  then  be  made  the  subject  of  further 
investigation. 

Stock  on  Hand. — The  valuation  of  the  stock  on  hand  is  likely 
to  present  considerable  difficulty.  The  usual  rule  of  valuing  the 
stock  at  ''cost  or  market,  whichever  is  lower,"  does  not  neces- 
sarily apply  in  such  a  case.  The  liquidating  partner  is  under 
obligation  to  secure  the  largest  return  for  all  the  assets  of  the 
business,  and  he  has  a  right  to  sell  the  stock  to  himself,  which 
he  is  in  effect  doing,  only  if  he  is  willing  to  pay  as  much,  or 
more,  for  it  than  can  be  secured  from  anyone  else.  This  is  not 
to  be  construed  as  meaning  what  can  be  secured  at  a  forced  sale. 

The  fairest  valuation  is  probably  the  cost  of  dupHcating  the 
stock  as  of  the  date  of  dissolution,  due  allowance  being  made  for 
obsolete  or  imperfect  stock.  If  the  inventory  includes  only 
staple  goods,  little  difficulty  is  encountered  in  ascertaining  the 
present  cost  of  dupHcating  them.  If  the  goods,  however,  have 
been  made  to  special  order,  or  are  otherwise  difficult  to  value, 
estimates  can  be  secured  from  manufacturers  for  making  similar 
articles,  or  the  actual  sales  of  the  goods  in  the  inventory  can 
be  traced  and  the  customary  rates  of  gross  profit  applied  to  esti- 


INVESTIGATIONS  4^7 

mate  the  cost.  These  matters  should  be  covered  by  an  agreement. 
In  drawing  such  agreements  the  auditor  should  be  consulted. 

If  it  be  agreed  to  value  the  stock  on  the  basis  of  cost,  it  is  to  be 
remembered  that  this  should  include  not  only  the  original  pur- 
chase price  of  the  goods,  but  also  freight,  cartage,  and  any  other 
direct  charges  for  handling  and  placing  the  goods  in  stock.  It  is 
sometimes  urged  that  the  term  ''cost"  in  such  a  case  should  in- 
clude interest  from  the  date  of  purchase  to  the  date  of  the  inven- 
tory. This  does  not  seem  logical,  however,  inasmuch  as,  if  mar- 
ket prices  are  still  the  same  as  at  the  date  the  goods  were  bought, 
the  fact  that  the  goods  have  been  in  stock  a  number  of  months 
does  not  add  to  their  value.  On  the  contrary,  the  longer  the 
goods  have  been  on  hand,  the  greater  is  the  probability  of  their 
already  being,  or  becoming  at  an  early  date,  unsalable. 

Apportionment  of  Profits  and  Losses. — Profits  realized 
or  losses  sustained  on  the  completion  of  contracts  made  prior  to 
the  dissolution  of  the  partnership  are  to  be  apportioned  between 
the  retiring  and  continuing  partners.  Inasmuch  as  the 
retiring  partner  shared  in  the  expenses  of  securing  the  contracts 
and  participated  in  the  risk  of  undertaking  them,  it  is  only 
fair  that  he  should  participate  in  the  profits  derived  there- 
from. On  the  other  hand,  he  should  also  help  to  bear  the 
burden  of  any  losses  sustained  in  carrying  out  contracts  which 
were  made  prior  to  the  dissolution  of  the  partnership.  There 
is  no  reason  why  the  continuing  partner  should  be  called 
on  to  bear  the  burden  alone,  unless  a  specific  agreement  is 
reached  under  which  the  continuing  partner  takes  over  the 
contracts  at  specific  values  and  assumes  all  further  risk  in  con- 
nection with  their  completion.  To  do  this  it  is,  of  course, 
necessary  to  secure  the  consent  of  all  other  parties  to  the  contracts, 
so  that  the  retiring  partner  or  his  estate  may  be  released  from  all 
liability  for  the  execution  of  the  contracts. 

Machinery  and  Fixtures.— Usually  the  most  equitable 
method  of  valuing  machinery  and  fixtures  seems  to  be  cost  less 


468  AUDITING— GENERAL  PRINCIPLES 

proper  depreciation  allowances.  If  this  differs  materially  from 
the  cost  of  reproduction  at  the  present  time  (also  making  allow- 
ance in  this  case  for  accrued  depreciation),  the  valuation  must 
probably  be  made  the  subject  of  compromise  between  the  parties. 

Miscellaneous. — While  the  correctness  of  the  balance  sheet 
is  of  pre-eminent  importance  in  an  investigation  such  as  the  one 
under  consideration,  the  correctness  of  the  income  account  is 
likewise  of  importance  if  the  good- will  is  valued  on  the  basis  of 
past  earnings.  It  is  also  necessary  to  review  the  expenses  enter- 
ing into  the  income  account  for  a  period  prior  to  the  date  of 
dissolution,  so  as  to  see  that  no  prepaid  expenses  which  apply 
subsequent  to  the  date  of  dissolution  have  been  absorbed  by  the 
old  business.  The  retiring  partner  will,  in  due  course,  be  debited 
with  his  proportion  of  all  expenses  chargeable  to  the  old  firm,  even 
though  they  may  not  have  appeared  among  the  liabilities  stated 
on  the  books  at  the  time  of  his  retirement.  Prepaid  expenses 
applying  to  the  new  business  are  not,  however,  so  likely  to  be 
brought  into  the  liquidation  account  if  they  were  absorbed  in  the 
operations  of  the  old  firm. 

There  are  still  other  questions,  such  as  partners'  salaries 
and  interest  on  partners'  accounts,  which  must  be  carefully 
considered  in  the  light  of  the  partnership  agreement. 

(j)  Investigation  for  Those  in  Charge  of  Reorganizations 

There  is  an  increasing  demand  for  the  services  of  accountants 
in  connection  with  reorganizations.  The  special  features  of  such 
examinations  are  admirably  expressed  by  Sir  A.  Lowes  Dickinson, 
C.P.A.,  in  his  work  '' Accounting  Practice  and  Procedure":^ 

The  consideration  of  a  plan  for  the  reorganization  of  a  property  which 
has  been  reduced  to  a  condition  of  insolvency,  requires  a  full  and  accurate 
knowledge  of  all  the  existing  conditions  with  regard  to  the  property  and  its 
past  and  probable  future  earning  capacity.  The  elements  to  be  investi- 
gated and  determined  will  therefore  be  as  follows: 


3  Page  245. 


INVESTIGATIONS  469 

1.  The  sources  and  nature  of  the  gross  earnings,  and  the  prospects  of 
any  increases  therein  without  further  expenditures  for  development. 

2.  The  cost  of  operation,  with  particular  reference  to  the  effect  thereon 
of  bad  management  or  bad  organization,  and  to  the  possibility  of  remedy- 
ing these  conditions;  and  the  proportion  which  the  cost  of  operation  has 
borne  and  may  be  expected  to  bear  to  the  gross  earnings. 

3.  A  comparison  of  the  gross  and  net  earnings  and  capitalization  of  the 
property  with  some  actual  or  desirable  standard,  so  as  to  determine  the 
proportion  which  one  should  bear  to  the  other  if  the  reorganization  is  to 
prove  successful. 

4.  Hence,  to  arrive  at  the  total  interest-bearing  and  dividend-paying 
capital  which  the  reorganized  property  will  stand  on  some  fixed  interest 
basis. 

5.  The  rank  of  the  different  classes  of  obligations,  having  regard  to  the 
property  pledged  as  security  therefor;  the  margin  of  security;  the  rate  of 
interest;  the  date  of  maturity;  the  equivalent  par  value  on  the  basis  of  the 
standard  rate  of  interest  adopted  for  all  classes;  and,  if  practicable,  the 
extent  to  which  the  properties  specifically  mortgaged  show  sufficient 
earnings  to  meet  interest  on  the  indebtedness  secured  thereon.  This  class 
of  information  will  probably  require  a  report  from  an  engineer  or  other 
expert  on  the  value  and  the  condition  of  the  physical  property. 

6.  Following  upon  the  determination  of  these  factors,  a  consideration 
of  the  various  separately  mortgaged  divisions  of  the  property,  with  a  view 
to  determining  whether  any  should  be  abandoned  to  the  bondholders, 
rather  than  be  included  in  a  reorganization;  and  here  it  is  important  to 
observe  that  the  contribution  of  any  specific  piece  of  property  to  the 
general  organization  is  not  necessarily  measured  by  its  ability  by  itself  to 
earn  interest  on  the  obligations  secured  thereon.  Numerous  other  factors 
will  enter  into  a  consideration  of  this  point,  and  it  may  easily  appear  that  a 
property  earning  little  or  nothing  towards  payment  of  its  obligations  is  suffi- 
ciently valuable  to  the  organization,  as  a  whole,  to  be  retained  if  possible. 

7.  Another  important  factor  is  the  amount  of  new  money  required  to 
be  introduced  for  the  purpose  of  paying  off  the  floating  debt  and  rehabilita- 
ting the  property,  and  the  best  method  of  raising  such  money — ^whether  by 
the  issue  of  new  prior  lien  securities  ranking  in  front  of  or  on  an  equali  y 
with  those  issued  in  exchange  for  existing  mortgages,  or  by  assessments  on 
junior  classes  of  securities.  In  the  latter  case  it  is  important  that  sufficient 
inducement  be  given  to  the  junior  classes,  in  the  proportion  of  new  securi- 
ties issued  for  old,  to  induce  them  to  pay  these  assessments;  while  for  the 
assessments  themselves,  the  securities  issued  should  represent  the  par 
value  of  the  cash  paid  in  on  some  reasonable  market  valuation. 


CHAPTER  XXII 

INVESTIGATIONS  (Concluded) 

Auditors  are  frequently  called  upon  to  make  examinations 
the  scope  of  which  is  practically  limited  to  certain  accounts  about 
which  the  most  complete  detail  is  required.  For  instance,  a 
manufacturer  may  desire  to  extend  a  large  line  of  credit  to  a 
jobber  or  merchant,  and  before  doing  so  wants  to  know  the 
latter's  capacity  for  handling  his  line,  as  well  as  to  know  that  his 
financial  condition  and  method  of  doing  business  are  satisfactory. 

INVESTIGATION  ON  BEHALF  OF  A 
PRESENT  OR  PROSPECTIVE  CREDITOR 

Examinations  along  these  lines  may  be  divided  into  two 
general  classes: 

For  bankers  or  note-brokers  who  propose  to  loan  on  the 
promissory  notes  of  the  borrower,  or  for  bankers  who 
propose  to  bring  out  bond  or  preferred  stock  issues. 

For  individuals  or  business  concerns  who  propose  to  make 
advances  for  various  purposes,  or  who  have  extended  or 
who  expect  to  extend  credit  on  open  account. 

In  the  main,  the  points  to  be  observed  have  been  discussed  in 
the  chapters  on  the  conduct  of  a  balance  sheet  audit,  but  there  are 
certain  special  precautions  which  may,  with  propriety,  be  en- 
larged upon  at  this  time. 

(a)  Examinations  for  Bankers 

Extension  of  Business. — The  most  important  line  of  ex- 
amination, after  ascertaining  the  assets  and  liabilities  and 
analyzing  the  income  account,  is  an  inquiry  into  the  plans 
for  the  future  which  have  been  adopted  or  which  are  under 

470 


INVESTIGATIONS  471 

consideration.  The  average  business  man  is  not  content  with  a 
stationary  business.  He  wishes  to  expand  for  the  purpose  of 
increasing  his  profits,  decreasing  his  expense  ratio,  and  perhaps 
the  most  compelHng  of  all  reasons  is  his  ambition  to  outstrip  his 
competitors. 

If  his  floating  debt  has  been  burdensome,  he  may  have  been 
obliged  to  keep  within  certain  bounds  as  to  capacity  and  pro- 
duction, but  the  moment  he  is  financed  it  seems  almost  inevitable 
that  new  liabilities  are  incurred  sufficient  to  use  up  the  additional 
supply  of  credit  almost  before  it  is  available. 

Accountants  do  not  always  feel  concerned  with  this  phase 
of  business  life,  but,  since  the  lender  should  have  some  means  of 
determining  the  use  to  which  his  money  is  to  be  put  other  than 
that  supplied  or  promised  by  the  borrower,  he  naturally  looks  to 
the  professional  auditor.  True,  he  has  looked  in  vain  in  many 
cases,  and  this  may  explain  the  reason  why  so  many  banks, 
bankers,  and  financiers  have  secured  the  services  of  men  who  can 
secure  and  impart  the  information  required,  whether  or  not  they 
have  the  degree  of  Certified  PubHc  Accountant. 

Collateral  versus  Integrity. — Which  is  better,  to  loan 
money  to  a  dishonest  man  on  ample  security,  or  to  a  perfectly 
honest  man  who  wishes  to  borrow  on  his  own  name  and  who  can- 
not furnish  collateral?  The  former  may  seem  to  be  more 
advisable,  but  there  are  disadvantages  in  doing  any  business 
whatever  with  a  man  who  cannot  be  trusted. 

In  a  federal  investigation,  the  late  J.  P.  Morgan  testified: 

Credit  is  personal.  Money  can't  buy  credit.  Men  can  borrow  money 
who  have  most  limited  properties.  The  first  thing  they  want  is  their 
record.  Money  is  loaned  on  collateral,  of  course,  but  I  would  not  lend  a 
dollar  to  a  man  whom  I  could  not  trust,  if  he  came  to  me  with  all  the 
government  bonds  in  Christendom. 

Therefore,  no  matter  how  good  the  collateral  may  be,  the 
banker  wants  more  information,  and  the  auditor  may  be  able  to 


472  AUDITING— GENERAL  PRINCIPLES 

furnish  it.  Facts  relative  to  previous  business  experiences, 
possible  failures  or  embarrassments  caused  by  speculation,  etc., 
can  be  secured  from  the  mercantile  agencies,  but  inside  infor- 
mation relative  to  the  personnel  of  the  organization  can  be 
furnished  by  the  auditor. 

Experience  has  demonstrated  that  where  partners  quarrel,  or 
where  one  does  all  the  work,  trouble  follows.  Large  concerns, 
solvent  so  far  as  finances  go,  have  been  placed  in  the  hands  of 
receivers  because  of  internal  dissensions.  A  banker  does  not 
want  to  make  a  loan  which  may  be  paid  off  eventually  by  a 
receiver,  even  if  the  assets  are  double  the  liabilities. 

Then  one  or  more  departments  of  the  business  may  be  weak. 
The  sales  force  may  be  highly  organized  and  efficient,  but  if 
the  manufacturing  department  is  poorly  managed,  or  is  not  co- 
ordinated with  the  sales  department,  the  results  will  not  be 
satisfactory. 

If  no  criticism  is  justified  and  a  man's  honesty  is  unquestioned, 
a  banker  may  prefer  the  risk  to  the  apparent  safety  of  a  loan 
secured  by  collateral.  It  has  been  said  that  ''a  crooked  borrower 
is  always  a  wise  window-dresser,"  and  this  observation  may  be 
enlarged  to  remind  the  banker  that  crooked  borrowers  when 
negotiating  a  loan  sometimes  offer  collateral  to  which  they  do  not 
have  title. 

Future  Business. — During  the  progress  of  any  audit  which 
comprehends  a  balance  sheet,  there  should  be  available  full  data 
with  respect  to  future  business  and  the  means  whereby  it  is 
proposed  to  finance  it. 

Schedules  of  orders  booked,  the  time  estimated  to  complete 
same,  the  cost  of  the  raw  materials,  labor,  and  other  manufactur- 
ing expenses,  the  time  within  which  the  proceeds  of  sales  will 
mature,  the  dates  by  which  the  liabilities  for  purchase  will  have 
to  be  discharged,  and  many  other  factors  are  all  to  be  compiled 
and  put  into  readable  and  dependable  form. 

If  funds  are  to  be  furnished  to  meet  pressing  obligations,  and 


INVESTIGATIONS  473 

if  any  increase  in  the  business  means  the  tying  up  of  additional 
cash  for  a  considerable  period,  then  there  may  be  a  hesitancy 
about  supplying  the  needs  unless  a  stipulation  is  furnished  that 
additional  business  will  not  be  sought  until  the  funds  with  which 
to  finance  it  are  in  sight.  The  auditor  who  can  secure  infor- 
mation of  this  nature  may  be  helpful  to  the  banker  and  even  more 
so  to  the  borrower,  for  it  is  of  no  permanent  advantage  to  the 
latter  to  be  tided  over  one  period  of  stringency  merely  to  be 
plunged  into  another  and  more  serious  situation. 

Bank  Loans  to  Be  Repaid. — The  auditor  must  bear  in  mind 
that  the  banker  whom  he  represents  in  these  investigations  is 
considering  the  investment  of  deposits  which  are  chiefly  payable 
on  demand,  therefore  he  is  not  contemplating  the  making  of  ?i 
permanent  loan,  but  one  which  will  be  repaid  within  a  com- 
paratively short  time.  If  a  banker  were  looking  purely  for 
security,  he  would  invest  a  large  portion  of  his  funds  in  real 
estate  mortgages.  The  security  might  be  better  than  commercial 
paper,  but  the  maturities  would  be  from  one  to  three  years,  and 
hence  entirely  unsuitable  for  his  purposes. 

If  the  auditor  ascertains  that  the  prospective  borrower  does 
not  expect  to  "clean  up "  at  least  once  a  year,  he  should  so  report 
to  his  client. 

(b)  Investigations  After  Bankruptcy 

Auditors  are  frequently  called  upon  by  creditors  or  other 
interested  parties  to  make  investigations  of  bankrupt  or  in- 
solvent concerns  and  to  report  upon  their  condition  and  the 
causes  of  insolvency.  The  detailed  work  of  examinations  of  this 
class  is,  in  the  main,  quite  similar  to  that  in  connection  with  a 
regular  audit.  Certain  features,  however,  call  for  special 
attention. 

These  examinations  fall  into  two  general  divisions: 

I .  To  serve  as  a  basis  for  intelligent  action  by  a  creditors' 
committee  in  connection  with  the  fihng  of  a  petition 


474  AUDITING— GENERAL  PRINCIPLES 

for  a  possible  extension  of  time,  or  preparatory  to  the 
liquidation  of  the  business  of  the  bankrupt. 
2.  To  furnish  information  and   assistance  incidental  to 
a  proper  consideration  of  an  offer  of  composition  or 
other  settlement. 

In  respect  to  the  former,  the  auditor  must  guard  against 
inflated  assets,  and  understated  and  omitted  liabilities,  whereas 
in  the  latter  case  the  reverse  conditions  must  be  looked  for.  The 
greatest  care  should  be  exercised  in  the  verification  of  the  assets 
and  liabihties,  and  documentary  evidence  in  support  thereof 
should  be  obtained  wherever  possible.  A  good  plan  is  to  secure, 
if  possible,  statements  rendered  by  the  bankrupt  to  credit  agen- 
cies, say,  a  year  or  so  prior  to  the  date  of  examination.  A  com- 
parison thereof  with  the  books  may  possibly  indicate  some  assets 
which  do  not  appear  on  the  latter. 

The  detailed  examination  should  extend,  at  least,  over  the 
period  during  which  preferential  transfers  or  payments  may  have 
been  made.  These  would  consist  of  transfers  of  property  while 
insolvent,  with  intent  ^o  hinder,  delay,  or  defraud  creditors;  or 
with  the  intention  to  prefer  one  creditor  over  others  of  the  same 
class.  Transfers  of  property  without  compensation,  or  at  un- 
reasonably low  valuations,  should  be  carefully  investigated 
and  scheduled,  and  special  attention  directed  thereto  in  the  report. 

The  accounts  should  be  carefully  examined  for  predated  pay- 
ments to  creditors,  chattel  mortgages  on  merchandise,  and  pay- 
ments to  creditors  charged  to  expense  accounts,  since  preferences 
are  sometimes  effected  in  this  manner. 

If  the  identity  of  the  merchandise  can  be  established  by 
numbers,  trade-marks,  or  other  symbols,  it  is  advisable  to  trace 
the  largest  items  in  verification  of  the  inventory  totals.  This 
may  also  disclose  shortages  of  goods  of  such  amounts  as  to  sup- 
port the  inference  that  goods  were  shipped  out  to  friends  or  rela- 
tives.    Instances  of  this  kind  are  of  frequent  occurrence. 

If  the  examination  is  made  in  connection  with  a  proposed 


INVESTIGATIONS  475 

settlement,  inventory  valuations  should  be  very  carefully  verified. 
Instances  are  known  in  which  undervaluation  was  attempted  by 
employing  excessively  low  prices.  Goods  stated  to  be  of  no  value 
because  of  alleged  damage  should  be  called  for  and  inspected.  If 
necessary,  the  services  of  an  expert  appraiser  should  be  had  for 
this  purpose.  Misstatement  of  inventories  is  more  frequently 
attempted  than  is  the  case  with  other  assets,  possibly  because 
detection  thereof  is  more  difficult.  The  auditor,  therefore,  must 
be  especially  vigilant  in  this  regard. 

It  is  extremely  important  to  vouch  cash  payments  during 
the  period  selected  for  review.  This  is  especially  true  of  all 
large  amounts. 

In  one  bankruptcy  case  it  was  found  that  cheques  were 
drawn  to  the  order  of  various  employees  who  posed  as  creditors. 
The  cheques  were  duly  cashed  and  the  proceeds  eventually  paid 
over  to  the  partners  of  the  concern  in  question. 

A  critical  scrutiny  of  the  receipts  and  payments  for  unusual 
items  may  sometimes  disclose  the  existence  of  a  silent  partner, 
as  evidenced  perhaps  by  interest  payments  or  remittances  for 
profits,  etc. 

The  accounts  receivable  should  be  closely  scrutinized,  deduc- 
tions made  for  the  doubtful  items,  and  the  bad  items  listed  sepa- 
rately. All  the  accounts  should,  if  possible,  be  confirmed  by 
correspondence.  Accounts  with  large  balances,  said  to  be  imcol- 
lectible,  should  be  regarded  with  suspicion  and  subjected  to 
independent  verification.  Inquiry  among  other  houses  in  the 
same  line  of  business  may  result  in  the  auditor's  finding  that  some 
of  the  alleged  doubtful  accounts  are  good. 

Accounts  with  salesmen  covering  goods  in  hand,  either  as 
samples  or  for  sale,  also  cash  advances  for  expenses,  commissions, 
etc.,  should  receive  careful  attention.  These  accounts  are 
frequently  stated  to  be  worthless  in  order  to  make  a  poor  showing 
and  thereby  to  induce  the  creditors  to  accept  an  unfavorable 
settlement.  Commissions  due  to  salesmen  should  be  verified 
by  reference  to  the  sales  records,  and  by  an  inspection  of  the 


476  AUDITING— GENERAL  PRINCIPLES 

salesmen's  contracts,  if  any  exist.  The  auditor  should  satisfy 
himself  that  the  commissions  stated  as  due  have  accrued  on  actual 
sales  and  that  the  respective  salesmen  are  entitled  thereto. 

With  reference  to  accounts  payable,  the  auditor  should  be 
certain  that  all  items  are  included  and  that  the  respective  amounts 
recorded  as  due  are  actually  owing.  He  should  also,  as  far  as 
possible,  establish  the  propriety  of  claims  presented  and  endeavor 
to  provide  for  all  possible  claims  not  received  at  the  time  state- 
ments are  submitted.  The  statements  usually  prepared  consist 
of  a  statement  of  affairs,  with  supporting  schedules,  and  a 
deficiency  account.  If  the  auditor  is  still  in  charge,  in 
cases  where  there  is  a  final  winding  up  of  affairs,  a  statement  of 
realization  and  liquidation  is  prepared. 

It  is  essential  in  this  class  of  examinations  for  the  auditor  to 
verify  and  account  for  all  the  assets  and  liabilities  that  appear  on 
the  books,  and  to  establish  the  possible  existence  of  assets  and 
liabilities  not  revealed  in  the  accounts.  He  must  be  extremely 
conservative  in  estimating  the  realizable  values,  always  keeping 
in  mind  that  his  report  will,  in  all  probability,  be  relied  upon  by 
the  creditors,  and  that  a  too  optimistic  report  results  in  dis- 
appointments that  reflect  on  his  accounting  ability. 

(c)  Investigation  for  Purely  Credit  Purposes 

The  credit  manager  of  a  business  concern  or  the  representative 
of  a  capitalist  who  contemplates  extending  credit  to  a  prospective 
borrower  or  debtor,  must  proceed  along  somewhat  different  lines 
than  the  professional  auditor,  whose  duty  is  to  report  upon  actual 
conditions,  and  upon  whom  the  responsibility  is  not  laid  of  hav- 
ing to  determine  immediate  action,  based  more  on  the  estimated 
outcome  of  the  future  than  on  present  financial  strength. 

For  instance,  an  auditor  may  ascertain  and  report  that  a 
certain  man  had  cash  on  hand  of  $100,000  and  no  debts.  He  has 
no  further  responsibility  thereafter,  unless  it  is  shown  subse- 
quently that  there  are  undisclosed  liabilities.  We  will  assume, 
however,  that  the  facts  were  as  reported. 


INVESTIGATIONS  477 

Task  of  Credit  Manager. — The  credit  manager  may  have 
an  entirely  different  task  before  him.  He  should  use  the  same 
means  to  ascertain  that  the  $100,000  was  actually  on  hand  and 
free  from  liens,  and  that  there  were  no  liabiUties,  but  his  work  is 
then,  in  a  sense,  merely  beginning.  He  should  ascertain  the  past 
and  present  moral  and  business  reputation  of  the  man;  he  should 
have  an  accurate  and  complete  history  of  his  business  career;  he 
should  question  him  in  detail  as  to  what  he  intends  to  do  with  the 
money;  whether  his  proposed  business  venture  calls  for  a  capital 
of  more  than  $100,000,  and  so  on. 

It  has  been  said  that  the  credit  manager  must  always  look  out 
for  three  essential  elements  in  passing  on  a  credit  basis,  viz., 
character,  capital,  and  capacity — three  "C's,"  and  therefore 
easily  remembered. 

Auditor  versus  Credit  Manager. — The  author  feels  that 
there  are  so  many  points  of  contact  between  a  professional  auditor 
and  a  credit  manager  that  this  opportunity  should  be  taken  to 
discuss  the  similarities  of  their  work,  with  a  view  to  standardizing 
as  much  of  it  as  possible. 

It  is  not  contended  that  the  auditor  should  attempt  all  the  mani- 
fold duties  of  the  credit  manager,  or  that  the  latter  should  burden 
himself  with  the  technical  knowledge  required  to  make  a  detailed 
audit.  It  is,  however,  urged,  without  fear  of  contradiction,  that 
an  auditor  is  able  to  render  better  service  to  his  clients  if  he  can 
acquire  some  of  the  instincts  of  the  successful  credit  manager 
and  keep  constantly  before  him,  when  making  investigations 
involving  proposed  credits  or  investments,  many  of  the  require- 
ments which  the  science  of  credits  has  found  to  be  essential. 
Likewise,  who  will  deny  that  the  credit  manager  could  perform 
his  work  more  easily  and  scientifically  if  he  were  conversant  with 
the  principles,  and  could  take  advantage  of  the  experience,  under- 
lying the  practice  of  professional  auditing? 

The  National  Association  of  Credit  Men's  bulletins  contain 
this: 


47^  AUDITING— GENERAL  PRINCIPLES 

The  giver  of  credit  is  a  contributor  of  capital,  and  becomes,  in  a  certain 
sense,  a  partner  of  the  debtor,  and,  as  such,  has  a  perfect  right  to  complete 
information  of  the  debtor's  condition  at  all  times. 

Credit  is  given  a  merchant  because  of  the  confidence  reposed  in  him. 
Requesting  a  statement  when  credit  is  asked  is  not  a  reflection  on  one's 
character,  honesty,  or  business  ability,  but  is  done  to  secure  information 
to  enable  business  to  be  conducted  inteUigently. 

When  a  statement  is  made  it  should  be  absolutely  correct.  To  make  it 
so  necessitates  the  taking  of  at  least  an  annual  inventory  and  the  keep- 
ing of  an  accurate  set  of  books.  Statement  giving,  therefore,  will  tend 
to  make  a  debtor  a  better  buyer,  because  more  familiar  with  his  stock, 
more  careful  in  giving  credit,  more  conservative  in  incurring  debt,  and  will 
result  in  a  better  knowledge  of  his  business  generally. 

A  merchatit  who  desires  to  serve  his  own  best  interests  should  recognize 
that  his  mrost  valuable  possession,  apart  from  his  actual  assets,  is  a  sound, 
substantial  and  unquestioned  reputation  as  a  credit  risk,  and  that,  under 
the  prevailing  conditions  and  demands  of  business,  the  most  effective, 
and  eminently  the  best  way  to  prove  his  basis  for  credit  is  to  be  willing 
to  submit  a  statement  of  his  financial  condition. 

The  liabilities  in  business  failures  aggregated  over  $430,- 
000,000  during  the  first  nine  months  of  1921.  The  annual 
average  has  been  in  excess  of  that  sum.  It  is  estimated  that  the 
loss  to  creditors  is  more  than  half  of  the  total  liabilities.  In  a 
very  large  proportion  of  these  cases  credit  could  not  be  secured  if 
the  debtor  were  obliged  to  submit  his  books  to  an  examination  by 
a  professional  auditor. 

Is  it  unreasonable  to  suppose  that  the  general  use  of  auditors 
to  verify  the  accounts  of  concerns  seeking  credit  would  save 
10  per  cent  of  the  annual  loss  of  nearly  $300,000,000?  If  a 
saving  of,  say,  $30,000,000  can  be  effected  by  the  expenditure 
of,  say,  $1,000,000,  is  it  not  worth  while  to  attempt  to  save 
another  10  per  cent  or  more  by  compulsory  audits  of  all  concerns 
seeking  credit? 

It  is  a  great  surprise  to  credit  managers  when  they  realize 
losses  from  respected  concerns — those  concerns  whose  state- 
ments the  bankers  and  credit  men  do  not  verify  personally,  or 
cause  to  be  verified  by  some  independent  means. 


INVESTIGATIONS  479 

Causes  of  Inaccuracies. — It  is  because  credit  managers  do 
not,  as  a  rule,  recognize  the  fact  that  most  concerns  cannot  be 
depended  upon  to  furnish  a  true  statement  of  their  financial  con- 
dition. Aside  from  fraud,  inaccuracies  (which  are  just  as  expen- 
sive as  fraud)  arise  from  the  following  causes: 

1.  The  fallibility  of  human  nature,  which,   with  respect 

to  financial  statements,  tends  to  optimism,  the  mak- 
ing the  best  of  things,  which  inevitably  leads  to  the 
perhaps  unconscious  overstatement  of  assets,  and 
understatement  of  liabilities. 

2.  The  inevitable  errors  which  arise  in  the  use  of  estimates, 

honest  errors,  but  errors  which  almost  always  result 
in  an  overstatement  of  net  worth. 

3.  Ignorance  of  executives  and  clerks,   inefficient  meth- 

ods and  systems,  resulting  in  misleading  statements  of 
financial  condition.  Strange  to  say,  such  statements 
nearly  always  overstate  net  worth. 

4.  Consciousness  of  weak  spots,  but  coupled  with  a  mental 

reservation  to  adjust  them  later. 

If  we  can  agree  that  the  factors  named  are  of  sufficient  impor- 
tance to  wai*rant  an  independent  verification;  if  it  is  true  that  for 
his  own  sake,  as  well  as  for  the  benefit  of  the  dispenser  of  credit, 
the  seeker  for  credit  should  have  his  statement  verified,  how  is  it 
to  be  done? 

The  answer  to  this  question  is  simple.  It  may  be  accom- 
plished by  proper  recognition  on  the  part  of  the  credit  manager  of 
the  value  of  verified  financial  statements  and  insistence  upon  the 
practice;  and  by  a  proper  recognition  on  the  part  of  the 
professional  auditor  of  the  point  of  view  of  the  credit  manager. 
The  responsibility  will  then  rest  upon  the  auditor  for  audit 
certificates  which  can  be  depended  upon. 

Unscientific  Methods. — Such  methods  affect  busmess 
success  quite  as  much  as  anything  else.  The  auditor  may  find  a 
satisfactory  surplus  of  assets,  but  if  carelessness  or  incompetence 


48o  AUDITING— GENERAL  PRINCIPLES 

exists  in  the  accounting  and  other  departments,  a  day  of  reckon- 
ing will  surely  arrive. 

Signs  of  carelessness  or  incompetence  may  be  found  in  lax 
collection  methods.  More  than  one  failure  has  resulted  from  a 
policy  of  allowing  collections  to  take  care  of  themselves. 

The  precise  procedure  followed  should  be  ascertained  and 
reduced  to  writing.  The  ''follow-up "  system  must  be  examined 
very  carefully.  It  may  be  that  the  system  is  good,  but  that  it  is 
not  being  followed.  Then  the  relation  between  the  departments 
must  be  looked  into.  Co-ordination  here  is  absolutely  essential 
to  success.  Sometimes  a  credit  department  claims  that  the  sales- 
men are  so  anxious  to  sell  that  a  considerable  part  of  the  business 
must  be  refused.  This  brings  up  the  question  of  co-ordination 
among  the  various  departments  of  a  business.  If  it  is  lacking, 
one  of  the  elements  of  failure  is  present. 

An  investigation  into  the  methods  of  doing  business  thus 
becomes  a  necessity  when  one  is  looking  into  the  future  probabil- 
ities of  success  or  failure.  Almost  anyone  can  sell  goods,  but  to 
insure  financial  success  they  must  be  sold  at  a  price  which  yields 
a  satisfactory  profit  and  to  customers  who  pay.  Here  again  the 
methods  of  the  prospective  debtor  are  all-important,  and  the 
representative  of  the  lender  or  creditor  not  only  has  the  right  to 
know  whether  or  not  scientific  methods  are  in  force,  but  it  is  his 
positive  duty  to  ascertain  whether  or  not  such  is  the  case. 
During  the  World  War,  in  most  lines  of  business  demand  exceeded 
supply.  Some  men  who  made  fortunes  under  those  conditions 
refuse  to  acknowledge  that  large  profits  could  have  been  made 
no  matter  how  badly  a  business  was  run.  Now  that  competition 
has  been  restored,  money  is  no  longer  to  be  made  easily. 

Lack  of  Capital. — It  is  said  that  more  failures  result  from 
lack  of  capital  than  from  any  other  cause.  It  may  seem  super- 
fluous to  state  that  it  is  better  to  do  a  small  but  safe  and  profitable 
business  than  to  attempt  to  trade  beyond  the  Hmits  of  capital 
employed;  yet  this  overstretching  is  going  on  all  the  time.     It  is 


INVESTIGATIONS  481 

a  point  on  which  the  auditor  and  credit  manager  can  secure 
accurate  information  from  the  balance  sheet,  but  this  must  be 
supplemented  by  an  inquiry  into  plans  for  extensions  to  plant, 
commitments  for  large  purchases  for  future  delivery,  and  similar 
negotiations. 

Credit  Risks. — The  passion  of  a  salesman  is  to  sell;  the 
dread  of  a  credit  manager  is  to  pass  a  credit  which  will  produce  a 
loss.  Between  the  two  may  lie  the  secret  of  a  successful  business 
and  large  profits.  The  burden  is  upon  the  credit  manager,  and  he 
cannot  escape  it  by  turning  down  every  order  about  which  any 
doubt  exists. 

The  conclusions  upon  which  he  bases  his  final  decision  in  any 
case  are  dependent  upon  so  many  different  circumstances  that 
they  cannot  be  enumerated  here,  but  it  may  be  mentioned  that 
the  margin  between  the  cost  and  selling  price  of  an  article  is  one 
of  the  most  important  factors  to  be  considered  when  the  question 
of  the  acceptance  or  rejection  of  an  order  is  to  be  settled.  If  the 
gross  profit  is  large,  it  is  obvious  that  more  risk  may  be  taken  than 
if  the  margin  of  profit  is  too  small  to  admit  of  any  material 
amount  being  set  aside  for  bad  debts. 

In  some  lines  the  gross  profit  is  so  large  that  it  is  more  eco* 
nomical  to  sell  everybody  than  to  maintain  a  credit  department; 
in  others  it  is  equally  imnecessary  to  maintain  such  a  department, 
because  all  goods  must  be  shipped  sight  draft  against  bill  of  lad- 
ing. The  point  seems  obvious  yet  many  accountants  and  credit 
managers  do  not  differentiate  between  the  rules  to  be  observed, 
thus  making  their  general  advice  of  little  or  no  value. 

Insurance. — A  professional  auditor  does  not  always  inquire 
into  the  sufficiency  of  insurance  of  all  descriptions,  but  it  is 
believed  that  the  successful  credit  manager  has  this  constantly 
in  mind.  Auditors  now  see  the  importance  of  this  line  of  inquiry, 
and  among  certain  firms  it  is  an  integral  part  of  the  audit  program. 

Fire  insurance  is  only  one  of  the  lines  which  should  be  investi- 
gated.    If  the  personality  of  a  partner  or  an  employee  is  of  great 

VOL.  I — 31 


482  AUDITING— GENERAL  PRINCIPLES 

value,  life  insurance  may  be  desirable.  Except  in  a  very  few 
lines  of  business,  such  as  railway  or  taxicab,  a  reasonable  amount 
of  liability  insurance,  both  public  and  employers',  should  always 
be  carried.  Rates  must  be  extremely  high  or  the  risks  must  be 
widely  scattered  to  justify  a  concern  in  carrying  the  risks  itself. 
Before  attempting  it  a  complete  investigation  should  be  made 
into  the  actual  results  realized  by  other  concerns  over  a  period  of 
years. 

Profit  insurance  is  frequently  as  important  as  fire  insurance, 
especially  if  a  seasonal  business  is  conducted,  and  large  prelimi- 
nary expenses,  such  as  advertising,  are  incurred,  and  if  a  total 
loss  would  result  if  a  factory  were  to  be  destroyed. 

Errors  of  Principle. — It  is  not  enough  that  a  concern's 
financial  statement  shall  look  well,  for  sometimes  actual  condi- 
tions are  concealed  through  errors  in  bookkeeping.  This  state  of 
things  exists  in  more  cases  than  is  generally  known. 

For  instance,  in  a  contracting  business  the  bookkeeper,  in 
closing  the  accounts,  closed  all  of  the  credit  balances  in  individual 
contract  accounts  to  income.  He  did  not  realize  that  all  of 
them  were  not  completed  and  that  a  considerable  Hability 
existed  in  respect  of  the  cost  of  completion.  His  balance  sheet 
showed  a  much  better  financial  position  than  the  concern 
deserved,  but  the  bookkeeper  maintained  that  it  was  correct  until 
he  was  shown  how  inaccurate  it  was. 

Errors  may  be  honestly  made,  and  yet  they  will  bring  ruin  on 
a  concern  unless  discovered  and  rectified.  Failure  to  provide  for 
depreciation  is  the  most  common  dereliction,  and  excessive 
charges  to  asset  accounts  is  a  close  second.  The  auditor  is  always 
on  the  lookout  for  such  errors,  whether  intentional  or  uninten- 
tional, but  few  credit  managers  realize  the  importance  of 
ascertaining  whether  or  not  the  books  of  a  prospective  debtor 
have  been  regularly  examined  by  a  public  accountant. 

Fraud. — Under  this  class  the  auditor  finds  far  too  many 
examples.     The  bankruptcy  courts  are  full  of  cases  in  which 


INVESTIGATIONS  4^3 

creditors  have  been  grossly  deceived.  Many  of  these  are  so 
flagrant  that  it  seems  impossible  that  the  debtors  should  have 
been  able  to  incur  such  large  debts,  yet  the  fact  is  obvious  that 
credit  managers  by  the  hundred  and  business  concerns  by  the 
thousand  extend  credit  to  these  bankrupts  to  an  aggregate  of  tens 
of  millions  of  dollars.  The  schedules  of  the  bankrupts'  debts 
speak  for  themselves.  The  most  surprising  feature  of  the  whole 
situation  is  that  in  many  cases  the  most  cursory  examination  of 
the  bankrupt's  books  would  have  revealed  to  the  trained  auditor 
that  gross  fraud  was  being  practiced.  A  more  intimate  relation- 
ship between  professional  auditors  and  credit  managers  would 
prove  to  the  latter  that  the  auditor  can  be  of  inestimable  service 
in  many  ways. 

Character. — Last  but  not  least  is  the  element  of  character. 
In  modern  business  it  is  almost  concealed,  owing  to  the  impossi- 
bility of  continuing  the  personal  relations  between  bankers  and 
borrowers.  The  modern  borrower's  balance  sheet  may  be 
submitted  to  hundreds  of  bankers.  But  the  author  would  not 
like  to  see  the  audit  program  of  the  auditor  or  credit  manager 
omit  all  consideration  of  character. 

The  banker  has  to  consider  primarily  the  present  ability  of 
the  borrower  to  repay  the  loan,  but  further  than  this  his  business 
foresight  makes  it  possible  for  the  banker  to  size  up  his  man  and 
determine  whether  there  is  not  some  inherent  lack  of  character  in 
him,  either  moral  or  executive,  which  may  at  some  future  time 
make  the  risk  more  hazardous  than  if  he  were  entirely  normal. 

Some  unprincipled  business  men  pay  all  of  their  debts,  but 
many  are  found  in  the  bankruptcy  courts  being  relieved  of  their 
obligations,  and  subsequent  success  does  not  incline  them  to  pay 
the  debts  thus  discharged. 

The  honest  man  may  fail  honestly,  but  if  he  can  he  will  pay 
in  time,  and  we  may  be  thankful  that  there  are  many  such. 
Therefore  let  the  auditor  and  the  credit  manager  study  human 
nature  and  analyze  the  conditions  presented  to  them,  not  only 


484  AUDITING— GENERAL  PRINCIPLES 

from  the  financial  standpoint  but  from  a  moral  point  of  view  as 
well. 

(d)  Investigation  in  Patent  Litigation 

An  investigation  to  ascertain  net  income  realized  in  the 
manufacture  of  patented  articles,  when  infringement  of  patent 
rights  is  claimed  and  the  claim  is  sustained,  or  when  an  examina- 
tion is  ordered  pending  a  decision,  presents  several  novel  features, 
as  compared  with  an  ordinary  statement  of  income. 

It  is  not  intended  to  discuss  the  matter  from  a  legal  point  of 
view,  and  it  may  be  that  the  principles  hereinafter  set  forth 
may  not  be  upheld  by  the  courts  in  some  jurisdictions.  It  is  the 
author's  experience,  however,  that  most  of  these  cases  are  settled 
out  of  court  owing  to  the  enormous  expenses  involved  in  the  tak- 
ing of  testimony  before  masters,  who  are  usually  appointed  where 
matters  of  account  are  involved. 

The  following  procedure,  therefore,  may  be  taken  as  the 
result  of  actual  practice,  following  negotiations  which  usually 
involve  concessions  on  both  sides,  rather  than  settled  rules  laid 
down  in  judicial  decisions. 

General  Accounting  Principles  Do  Not  Govern. — The 
preliminary  conferences,  in  a  matter  of  this  sort,  naturally  bring 
out  opinions  which  differ  radically.  The  injured  party  claims 
everything  that  can  be  imagined,  and  the  defendant  produces  a 
statement  which  shows  that  the  manufacture  of  the  infringing 
article  has  been  attended  with  ruinous  losses.  From  the  begin- 
ning it  is  a  question  of  gradually  drawing  the  lines  closer,  until 
each  has  stripped  his  case  of  redundant  matters  and  the  issue 
is  joined. 

Ordinary  accounting  principles  do  not  form  the  basis  of  the 
claim  nor  of  the  defense.  The  following  are  exceptions  to 
accepted  practice : 

There  seems  to  be  no  reason  for  apportioning  any  part  of 
the  general  expenses  as  a  part  of  the  cost  of  the  business.    The 


INVESTIGATIONS  4^5 

infringers  would  have  had  these  expenses  to  pay  in  any  event 
in  order  to  carry  on  their  legitimate  business. 

If  the  principal  business  of  the  defendants  consists  of  manu- 
facturing or  dealing  in  infringing  articles,  then  it  may  be  proper 
to  include  a  certain  part  of  the  general  expenses,  but  items  of  a 
questionable  nature  should  not  be  included. 

As  defendants  are  not  supposed  to  have  pushed  the  sale  of 
the  article,  it  hardly  seems  proper  that  any  credit  should  be 
claimed  for  special  exhibitions. 

If  the  same  kind  of  materials  is  legitimately  used  in  the  manu- 
facture of  other  goods  handled  by  the  defendants,  and  the  purchases 
are  not  earmarked  at  the  time  for  any  particular  department,  it 
seems  improper  that  credit  should  be  allowed  for  any  materials 
not  clearly  identified  as  having  been  used  in  the  infringing  product. 

Based  on  similar  accountings,  the  defendants  are  not  entitled 
to  place  a  scrap  valuation  upon  materials  remaining  on  hand  when 
they  were  compelled  to  stop  the  sale  of  the  article,  but  they  could 
be  compelled  to  scrap  the  articles  on  hand  at  that  time,  and 
would  not  be  entitled  to  any  credit  whatever  for  the  entire  cost  of 
the  manufacture  of  said  stock. 

It  does  not  seem  conceivable  that  the  defendants  would  be 
permitted  to  make  a  profit  out  of  their  wrongdoing,  and  this 
would  be  the  result  if  general  expenses  and  similar  items  were 
included,  as  the  tendency  would  be  to  reduce  the  expenses  of 
conducting  their  legitimate  business.  If  they  have  been  ordered 
to  account  for  the  profit  made  by  them  in  the  manufacture  and 
sale  of  articles,  the  courts  undoubtedly  should  hold  that  the  word 
*' profit"  as  here  used  means  the  difference  between  the  proceeds 
from  the  sale  of  an  article  and  the  prime  cost  (that  is,  labor  and 
material)  of  such  sales,  and  that  the  cost  of  goods  on  hand  at  the 
end  of  the  period  should  not  be  treated  as  an  item  of  cost  for 
which  credit  can  be  claimed. 

Court  Decisions. — The  courts,  however,  do  not  seem  tr 
accept  the  foregoing  view.     In  the  case  of  Rubber  Company  v. 


486  AUDITING— GENERAL  PRINCIPLES 

Goodyear, '  where  a  master's  report  was  being  commented  upon, 
the  court  said: 

He  refused  to  allow  manufacturer's  profits  and  interest  on  the  capital 
stock.  This  was  correct.  *  'The  profits  made  in  violation  of  the  rights  of  the 
complainants"  in  this  class  of  cases,  within  the  meaning  of  the  law,  are  to  be 
computed  and  ascertained  by  finding  the  difference  between  cost  and  yield. 
In  estimating  the  cost,  the  elements  of  price  of  materials,  interest,  expenses 
of  manufacture  and  sale,  and  other  necessary  expenditures,  if  there  be  any, 
and  bad  debts,  are  to  be  taken  into  the  account,  and  usually  nothing  else. 
The  calculation  is  to  be  made  as  a  manufacturer  calculates  the  profits 
of  his  business. 

In  Am  Ende  v.  Seabury,^  the  court  said: 

The  master  properly  refused  to  allow  the  defendant,  as  an  element  of 
the  "factory  cost,"  .  .  .  interest  on  the  capital  of  the  corporation 
invested  in  the  business. 

FRAUD 

Following  the  discovery  of  an  embezzlement  may  be  heard 
expressions  of  surprise,  based  on  the  fact  that  the  embezzler  was  a 
trusted  employee.  It  does  not  seem  to  occur  to  most  people  that, 
generally  speaking,  no  one  but  a  trusted  employee  has  an  oppor- 
tunity to  defraud  others.  Every  year  some  trusted  employees 
prove  recreant  to  their  trust;  therefore  mere  business  prudence 
demands  some  form  of  supervision  over  all  those  who  have  a 
chance  to  appropriate  to  their  own  use  the  property  of  others. 

In  the  preceding  chapters  an  attempt  has  been  made  to  out- 
line the  procedure  required  in  audits  of  various  natures,  but  the 
procedure  there  referred  to  was  not  intended  to  cover  those  cases 
in  which  a  particular  person  is  under  suspicion  or  in  which  a 
particular  form  of  fraud  is  suspected,  or  has  been  discovered,  and 
in  which  it  is  important  to  locate  the  guilty  party  or  parties  without 
delay. 

^  76  U.  S.  788. 

=  43  Fed.  Rep.  672. 


INVESTIGATIONS  4^7 

Then,  again,  it  may  be  that  an  audit  has  been  made  along 
usual  lines  without  developing  anything  wrong;  but  it  is  found 
that  an  employee  is  living  beyond  his  means,  or  is  constantly 
seen  in  bad  company,  so  that  a  special  investigation  becomes 
desirable.  The  point  immediately  arises  as  to  whether  there 
are  any  special  checks,  or  verifications,  which  are  not  usually 
resorted  to  in  an  ordinary  audit,  but  which  may  be  useful  when 
applied  to  specific  cases. 

Possibilities  to  Be  Studied 

In  all  cases  where  suspicion  exists,  the  quickest  way  to  locate 
fraud  is  to  ascertain  definitely  the  opportunities  which  are  nor- 
mally open  to  the  person  suspected,  and  the  possible  chances 
which  may  not  be  usually  open  to  such  person,  but  of  which  he 
may  have  taken  advantage. 

For  instance,  the  treasurer  of  a  company  may  be  known  to  be 
spending  more  than  his  income,  and  an  inquiry  is  ordered.  If  the 
business  is  at  all  large,  it  is  obviously  not  worthwhile  to  commence 
the  investigation  in  the  same  way  as  a  general  audit,  but  the  wise 
course  is  to  look  into  the  matters  under  the  personal  charge  of 
that  officer.  Any  securities  supposed  to  be  in  his  hands  should  be 
called  for,  and  the  method  of  handling  cash  transactions  should 
be  inquired  into.  If  he  has  always  insisted  on  opening  the  mail, 
it  may  be  that  customers'  accounts  have  been  tampered  with; 
if  he  has  assumed  personal  charge  of  the  periodical  reconciliation 
of  the  bank's  pass-books  with  the  bank  balance,  it  may  be  that 
funds  have  been  withdrawn  from  the  bank  and  not  reported. 

If  the  gross  income  is  unexpectedly  small,  it  may  be  that  stock 
is  being  stolen  or  that  fictitious  purchases  appear  in  the  books. 

Extent  of  Fraud 

Frequently  the  professional  auditor  is  not  called  in  until  the 
embezzlement  has  been  disclosed  and  his  services  are  desired  to 
fix  the  total.  In  such  a  case  experience  is  invaluable,  for  the 
position  of  the  auditor  may  be  a  most  difficult  one.    The  em- 


488  AUDITING— GENERAL  PRINCIPLES 

bezzler  usually  is  called  upon  to  give,  or  proffers,  his  assistance, 
and  professes  to  be  most  anxious  to  help  get  at  the  whole  truth. 
He  states  the  total  amount  as  positively  not  exceeding  a  certain 
total,  and  his  employer  is  apt  to  believe  him  and  to  doubt  the 
auditor,  whose  experience  warrants  him  in  stating  that  thieves 
rarely  tell  the  truth,  and  that  embezzlers  hardly  ever  know  the 
extent  of  their  own  fraud,  and  when  they  do  know,  understate 
it  materially  in  the  hope  that  their  attempts  at  concealment  may 
be  at  least  partially  successful. 

There  is  only  one  safe  rule,  and  that  is  to  calculate  every 
possible  source  of  income  open  to  the  embezzler,  the  maximum 
amount  of  such  income,  and  the  longest  time  possible  during 
which  the  fraud  may  have  been  going  on. 

Records  are  often  destroyed  and  many  sources  of  income 
cannot  be  traced  subsequently;  therefore  it  is  never  wise  to  take 
the  word  of  an  embezzler  for  the  amount  of  his  theft. 

Attitude  Toward  an  Embezzler 

Whenever  possible,  the  embezzler  should  be  required  to  attend 
and  assist  the  auditor.  This  does  not  mean  that  his  word  is  to  be 
taken  blindly  or  that  he  is  to  be  left  alone  with  the  books,  but  he 
can  do  no  harm,  and  in  countless  cases  his  presence  has  been  of  the 
greatest  assistance. 

Here  the  experience  and  skill  of  the  auditor  have  full  play. 
By  the  exercise  of  tact  he  may  persuade  the  criminal  to  disclose 
many  things  which  the  closest  examination  of  the  records  would 
not  reveal.  A  clue  is  often  as  valuable  as  a  complete  disclosure, 
and  it  rarely  happens  that  a  trained  auditor  spends  any  consider- 
able time  with  an  embezzler  without  discovering  directly  or  in- 
cidentally the  system  employed  and  other  valuable  information. 

No  one  knows  so  well  as  professional  auditors  how  small  a 
proportion  of  these  crimes  are  made  public,  but  embezzlers  them- 
selves seem  to  feel  intuitively  that  if  they  promise  to  tell  all  they 
know  and  to  make  restitution,  all  will  be  forgiven  and  forgotten. 
Unfortunately,  from  the  standpoint  of  example  this  is  often  too 


INVESTIGATIONS  4^9 

true,  but,  even  though  it  is  true,  there  can  be  no  objection  to  an 
auditor  pointing  out  to  the  embezzler  the  fact  that  if  he  lies  to  him 
(the  auditor),  it  will  aggravate  his  possible  punishment.  If  an 
examination  is  likely  to  result  in  litigation,  the  auditor  must  pay 
particular  attention  to  any  admissions  or  statements  by  the  sus- 
pected party . 

The  chairman  of  a  board  of  water  commissioners  kept  a  cash 
book  showing  his  receipts  and  disbursements.  When  the  balance 
was  ascertained  by  auditors  appointed  by  the  municipality,  the 
chairman  was  informed  of  the  amount  shown  by  the  book  to  be 
due  from  him,  the  correctness  of  which  he  did  not  dispute.  On 
being  asked  if  he  could  explain  the  balance  against  him,  he  said  he 
could  not,  and  being  then  told  that  it  would  have  to  be  reported 
to  the  authorities,  he  replied :  ^'  Well,  you  will  just  have  to  report 
it."  When  he  refused  to  pay  subsequently  and  suit  was  brought, 
the  court  held  that  this  was  sufficient  evidence  upon  which  to 
recover  the  balance. 

This  supports  the  principle  of  law  that  the  statement  of  an  ac- 
count need  not  be  confined  to  the  original  parties.  The  auditor  may 
have  an  exceptional  chance  to  secure  an  admission,  and  if  there  is 
any  likelihood  of  its  being  used  later,  he  should  reduce  it  to  writ- 
ing at  once.   This  record  may  be  useful  in  refreshing  his  memory. 

Definitions 

Auditors  usually  work  for  or  with  lawyers  in  cases  of  fraud, 
and  it  is  well  for  them  to  understand  the  legal  significance  of 
terms  in  general  use. 

Forgery. — Auditors  should  be  familiar  with  the  legal 
definition  of  ''forgery,"  which  is  broader  than  the  usual  under- 
standing of  its  meaning.  A  recognized  definition  is  the  following : 
^'  The  false  making  or  materially  altering,  with  intent  to  defraud, 
of  any  writing  which,  if  genuine,  might  apparently  be  of  legal 
efficacy  or  the  foundation  of  a  legal  liability."^ 


3  2  Bishop's  Criminal  Law,  Section  523. 


490  AUDITING— GENERAL  PRINCIPLES 

Fraud,  as  applied  to  accountancy  matters,  embraces  all 
dishonest  or  deceitful  acts  whereby  the  owner  of  property  is 
deprived  thereof  without  his  knowledge  or  consent.  The  inten- 
tion to  deceive  is  a  characteristic  of  fraud,  but  deceit  in  itself 
does  not  reach  the  gravity  of  fraud. 

Embezzlement  is  the  fraudulent  appropriation  to  one's  own 
use  of  the  money  or  goods  intrusted  to  his  care  by  another.  The 
auditor  should  distinguish  embezzlement  from  larceny  or  theft, 
because  in  the  case  of  embezzlement  the  original  custody  or 
receipt  of  the  money  or  other  property  was  lawful,  or  with  the 
consent  of  the  owner,  while  in  larceny  the  felonious  intent  must 
have  existed  at  the  time  of  the  taking.  Therefore,  if  an  ofhce  boy 
takes  and  retains  currency  out  of  a  cash  drawer,  he  is  guilty  of 
larceny.  If  the  cashier  takes  and  retains  it,  he  is  guilty  of 
embezzlement.  In  other  words,  there  must  be  a  relation  of 
special  trust  in  regard  to  the  property  appropriated,  and  it  must 
be  by  virtue  of  such  employment  that  the  money  or  other  prop- 
erty comes  into  the  possession  of  a  person  to  make  it  embezzle- 
ment within  the  meaning  of  the  statutes. 

Misappropriation  is  not  a  technical  term  of  law,  but  is  ap- 
plied to  the  actions  of  those  who  fraudulently  deal  with  money 
intrusted  to  them.  The  correct  term  for  such  an  act  is 
^'embezzlement." 

Defalcation  is  not  a  technical  term.  As  a  default  usually 
implies  that  property  appropriated  to  one's  own  use  originally 
came  into  his  possession  legally,  the  correct  term  is  ''embezzle- 


CHAPTER   XXIII 
THE  DETAILED   AUDIT 

GENERAL   PRINCIPLES 

The  chief  point  of  distinction  between  balance  sheet  and 
detailed  audits  is  that  in  balance  sheet  audits  the  work  centers  at 
a  specified  date,  whereas  in  detailed  audits  the  transactions 
during  a  fiscal  period  must  all  be  verified;  it  is  true  that  the 
verification  consists  largely  of  review  and  tests,  none  the  less  the 
tests  must  cover  the  entire  period  under  review.  In  detailed  audits 
as  well  as  in  balance  sheet  audits,  balance  sheet  items  must  be 
verified.  Likewise,  in  both  classes  of  audits  reports  dealing 
with  the  work  accomplished  must  be  rendered.  Before  starting 
detailed  audits,  the  auditor  should  acquaint  himself  with  the 
points  discussed  in  the  preceding  chapters,  make  all  relevant 
matters  a  part  of  his  audit  program,  and  in  addition  give  con- 
sideration to  the  following  new  points  which  need  not  be  dealt 
with  in  balance  sheet  audits. 

Completed  Audit 

It  was  stated  on  page  6i  that,  before  commencing  an  audit, 
the  auditor  should  secure  a  correct  trial  balance  as  of  the  closing 
date.  This  appHes  to  the  completed  audit,  that  is,  an  audit  made 
where  a  complete  accounting  period  has  elapsed  and  for  which 
a  final  report  is  to  be  made  on  the  work  accomplished.  The 
procedure  outlined  in  this  and  succeeding  chapters  describes 
the  procedure  for  a  completed  audit. 

Continuous  Audit 

This  term  applies  to  the  supervision  by  an  auditor  who 
attends  at  intervals  during  a  period,  and  each  time  makes  a 

491 


492  AUDITING— GENERAL  PRINCIPLES 

progress  report  instead  of  a  report  which  embodies  a  balance 
sheet  and  an  income  account. 

The  auditor  who  is  retained  to  audit  the  accounts  and  pass  on 
or  prepare  monthly  reports  may  be  said  to  make  a  completed 
audit,  although  in  some  cases  part  of  the  audit  work  is  left  un- 
finished until  the  end  of  the  fiscal  period. 

When  to  Do  Work. — When,  in  large  enterprises,  a  detailed 
audit  is  made,  the  auditor  may  arrange  to  perform  part  of  the 
work  during  the  term,  in  order  to  avoid  congestion  near  the  end  of 
the  period.  Sometimes  the  chent  requests  that  frequent  visits 
be  made,  so  that  if  errors  of  principle  or  clerical  errors  are  being 
made  they  can  be  detected  and  corrected  before  much  damage  is 
done.  It  is  important,  too,  that  if  fraud  is  being  practiced  it 
should  be  discovered  at  the  earliest  possible  date.  Furthermore, 
frequent  and  unexpected  visits  tend  to  keep  the  client's  staff 
up  to  date  in  their  work,  to  disclose  carelessness  as  well  as  actual 
errors,  and  to  create  a  good  moral  effect. 

If  much  detail  work  is  to  be  verified,  it  should  be  completed 
as  soon  after  the  closing  date  as  possible,  in  order  that  the  audi- 
tor's report  may  be  submitted  as  soon  as  possible  thereafter. 

Manipulation  of  Accounts. — When  interim  audits  are 
made  and  when  the  auditor,  in  subsequent  audits,  relies  on  the 
work  of  these  previous  visits,  he  should  take  care  that  the  figures 
which  he  has  passed  have  not  been  tampered  with  in  order  to 
conceal  fraud.  The  author  is  not,  however,  prepared  to  offer 
suggestions  for  the  detection  of  manipulation  of  accounts  after 
they  have  been  audited.  In  the  preparation  of  the  balance 
sheet  and  income  account,  if  the  accounts  are  analyzed,  un- 
•authorized  alterations,  if  any,  will  probably  be  revealed.  Experi- 
ence has  demonstrated  that  such  a  contingency  is  a  remote  one 
and  that  the  intuition  of  the  auditor  guards  against  it  better  than 
do  certain  set  rules. 

Completed  audits  are  fast  supplanting  continuous  audits,  and 
so  it  is  deemed  to  be  of  more  importance  here  to  describe  the 


THE  DETAILED  AUDIT  493 

former  fully.     The  auditor  who  masters  all  the  essentials  of  a 
completed  audit  can  readily  prepare  for  a  continuous  audit. 

Auditing  by  Tests  and  Scrutiny 

In  various  sections  of  this  book  the  author  refers  to  "tests'' 
or  to  "tests  and  scrutiny."  The  application  of  these  terms 
must  not  be  misunderstood,  particularly  with  reference  to 
detailed  audits.  In  a  business  of  any  considerable  size  it  is  a 
physical  impossibility  for  the  auditor  to  verify  every  entry  in  the 
books  within  a  reasonable  period  of  time,  nor  is  it  necessary  in 
most  cases,  even  where  carelessness  and  fraud  exist. 

"Test"  Defined.— The  following  definitions  of  the  word 
"test"  indicate  its  scope: 

1.  To  try  by  subjecting  to  some  experiment,  or  by  examina- 

tion and  comparison;  to  subject   to   conditions   that 
disclose  the  true  character  of. 

2.  An  examination  made  for  the  purpose  of  proving  or  dis- 

proving some  matter  in  doubt. 

Using  the  word  "test"  in  this  broad  sense  the  auditor,  by 
experience,  learns  to  eliminate  unnecessary  and  time-consum- 
ing work  and  to  substitute  therefor  necessary  and  constructive 
work. 

"Scrutiny." — It  is  suggested  that  in  some  cases  tests  of 
certain  periods  or  certain  quantities  justify  the  auditor  in  con- 
cluding that  the  transactions  during  other  periods  and  of  other 
quantities  are  correct,  if  no  errors  are  disclosed  by  such  tests. 
This,  however,  does  not  always  relieve  the  auditor  from  the  duty 
of  scrutinizing  the  transactions  of  the  uncovered  period,  and  the 
verified  quantities.  The  word  "scrutiny,"  as  used  here,  is 
supplementary  to  the  word  "test." 

The  time  consumed  in  verifying  in  detail  all  items  applicable 
to  a  limited  period  may  be  considerable;  however,  an  experienced 
auditor,  in  a  relatively  much  shorter  time,  can  scan  the  unverified 


494  AUDITING— GENERAL  PRINCIPLES 

items  for  unusual  items  or  suspicious  entries.  It  is  confidently 
predicted  that  an  audit  program  based  on  these  principles  will 
disclose  any  practice  subject  to  criticism. 

THE  AUDIT   OF   EARNINGS   AND   EXPENSES 

General  Principles 

Two  underlying  principles  govern  procedure  in  the  detailed 
audit  of  earnings  and  expenses : 

1.  The  auditor  must  ascertain  whether  the  earnings  shown 

by  the  books  are  properly  accounted  for,  and  whether 
any  of  the  earnings  are  omitted  therefrom. 

2.  He  must  ascertain  whether  the  expenses  and  losses  are 

properly  stated  and  supported. 

The  Clerical  Staff. — At  the  commencement  of  a  detailed 
audit  the  auditor  should  investigate  thoroughly  the  relation 
of  the  clerical  staff  to  the  work  and  to  each  other.  Auditors  are 
fond  of  stating  that  a  cashier  should  never  have  access  to  the 
ledgers,  and  that  a  ledger  clerk  should  never  have  access  to  the 
cash.  Theoretically  this  is  an  ideal  condition  and  actually  exists 
in  most  large  concerns;  not,  however,  because  the  proprietors 
realize  that  it  is  a  proper  safeguard,  but  because  there  is  enough 
work  of  each  class  to  warrant  using  the  whole  time  of  one  clerk  for 
it.  But  in  a  small  business  where  the  cashier's  duties  are  not  exten- 
sive enough  to  keep  him  busy  all  the  time,  he  is  required  to  assist 
with  other  duties,  and  naturally  he  is  expected  to  undertake  the 
work  for  which  he  is  best  qualified — posting  to  the  ledgers.  So 
long  as  there  are  proprietors  who  consider  that  a  bookkeeper's 
duties  comprise  those  of  a  cashier  as  well  as  those  of  a  ledger 
clerk,  it  will  be  necessary  to  exercise  special  vigilance  in  the  audit 
of  their  accounts ;  for  fraud  is  so  easily  concealed  that  many  clerks 
yield  to  temptation,  knowing  that  their  defalcation  will  not  be 
disclosed  unless  a  professional  auditor  is  employed. 

In  many  instances  where  professional  auditors  have  been 


THE  DETAILED  AUDIT  495 

expected,  the  clerks  have  used  most  ingenious  means  to  conceal 
their  fraud.  Consequently,  an  auditor  should  have  a  knowledge 
of  as  many  of  these  subterfuges  as  possible  in  order  to  detect 
irregularities  of  any  nature. 

Prior  Periods 

In  a  detailed  audit  covering,  say,  a  year,  the  question  fre- 
quently arises :  What  is  the  auditor's  responsibility  for  the  period 
prior  to  the  commencement  date?  He  should,  of  course,  have  it 
definitely  understood  that  the  commencing  date  be  definitely 
fixed  and  be  supported  by  a  balance  sheet  which  is  assumed  to  be 
correct. 

As  a  matter  of  fact,  there  is  little  danger  in  this  procedure. 
A  proper  audit  for  a  given  year  sheds  much  light  on  the  operations 
of  the  period  immediately  preceding.  If  nothing  in  the  current 
work  gives  rise  to  suspicion,  the  accounts  of  the  preceding  period 
may  be  left  undisturbed.  Of  course,  if  any  special  reason  exists, 
or  if  a  client  insists  on  going  back  for  two  or  more  years,  the 
auditor  must  comply;  but  he  should  then  make  the  suggestion 
that  the  last  year  should  be  audited  and  reported  upon  first,  so 
that  there  will  be  a  chance  for  reflection  before  incurring  the 
expense  incident  to  a  long  engagement. 

The  Accrual  Method 

To  be  correct,  the  income  account  for  a  given  period  must 
contain  all  of  the  earnings  or  revenue  and  all  of  the  expenses  or 
costs  applicable  to  that  period.  All  transactions  during  the 
current  period  which  apply  to  a  previous  period  should  have 
been  included  in  that  period,  and  all  transactions  which  belong 
to  the  succeeding  period  or  periods  must  be  deferred.  In  the 
former  case,  if  proper  reserves  were  set  up  for  the  items,  no 
adjustment  is  necessary  in  the  current  period.  If  the  accounts 
of  the  prior  period  were  closed  without  making  provision  there- 
for, obviously  the  items  must  be  entered  in  some  place.  If  the 
amounts  are  very  small  and  do  not  substantially  affect  the  result 


496  AUDITING— GENERAL  PRINCIPLES 

of  the  current  period,  it  is  permissible,  and  if  the  amounts  are 
quite  small,  almost  necessary,  to  enter  the  items  as  current  trans- 
actions. If  the  amounts  are  substantial  it  is  misleading  to  enter 
the  items  as  current  transactions;  they  should  be  credited  to  or 
charged  against  surplus,  but  in  all  cases  the  aggregate  of  such 
adjustments  should  be  included  as  a  special  item  in  the  income 
account  for  the  current  period.  Otherwise  the  items  will  not 
appear  in  any  income  account. 

It  is  hardly  possible  that  an  accurate  balance  sheet  or  income 
account  of  any  business  can  be  prepared  unless  the  accrual  basis 
is  adopted.  Concerns  which  close  their  books  immediately  after 
the  end  of  a  fiscal  period  almost  always  fail  to  include  some  items 
which  belong  in  such  period.  In  practically  all  cases  the  omitted 
items  are  expenses,  rather  than  earnings,  so  that  the  errors  due 
to  omission  usually  unduly  increase  the  net  income.  It  is  there- 
fore important  for  an  auditor  to  advise  that  books  be  left  open 
long  enough  to  ascertain  the  amount  of  liabilities  which  have  been 
incurred  but  not  discharged  at  the  closing  date. 

Verification  of  Footings  and  Postings 

The  least  important  part  of  the  audit  is  the  verification  of 
footings  and  postings.  It  is  a  very  small  business  indeed  where 
there  can  be  any  justification  for  verifying  every  posting  and 
every  footing.  In  past  years  about  half  of  the  auditing  consisted 
of  the  laborious  work  of  checking  postings  in  detail  and  verifying 
the  footings  of  all  books,  including  the  ledgers.  An  analysis  of 
various  defalcations  which  have  occurred  in  recent  years  demon- 
strates that  the  percentage  of  frauds  which  have  been  concealed 
by  false  postings  and  incorrect  footings  is  small.  This  small 
percentage  may  be  covered  just  as  well  in  what  may  be  called  a 
^'  test "  audit  as  in  a  so-called  detailed  audit.  If  books  are  out  of 
balance,  it  is  desirable  to  check  as  many  postings  and  footings 
as  possible.  This  not  only  gives  the  auditor  a  chance  to  see  at  first 
hand  the  sort  of  errors  which  the  bookkeepers  have  been  making 
and  thus  furnishes  data  for  his  report  but  it  also  helps  along  the 


THE  DETAILED  AUDIT  497 

current  work.  Then,  too,  if  all  the  differences  are  located,  he 
earns  the  good-will  of  the  bookkeeper,  which  is  an  important 
matter.  Undertaking  this  kind  of  work  is  dangerous,  however, 
unless  it  has  been  definitely  arranged  with  the  client  and  unless 
he  understands  that  part  of  the  work  being  done  is  that  of  an 
accountant  and  part  that  of  an  auditor. 

Tests  by  Ledger  Analysis. — Some  auditors  test  the  ledger 
postings  by  making  up  their  own  controlling  accounts,  or,  revers- 
ing the  process,  by  analyzing  each  ledger  account,  they  extract 
the  totals  of  each  source  of  original  entry.  There  are  very 
exceptional  cases  where  this  plan  may  be  followed,  principally 
where  the  ledger  is  not  in  balance.  It  is  an  old-fashioned  scheme, 
however,  and  has  no  place  in  modern  methods  of  auditing.  The 
auditor  who  knows  how  to  prove  such  work  by  tests  and  scrutiny 
works  at  a  great  advantage  and  thus  gains  valuable  time  which 
can  be  devoted  to  more  important  work — more  important  because 
the  largest  number  of  frauds  are  found  elsewhere  than  in  footings 
and  postings.  Therefore,  in  that  vast  number  of  audits  where 
there  has  been  no  fraud,  but  where  the  auditor  wishes  to  justify 
his  employment,  all  the  constructive  or  labor-saving  suggestions 
will  arise  from  the  other  portions  of  the  work. 

Subdivision  of  Time  to  Kinds  of  Work. — Many  audits 
have  required  four  weeks,  three  of  which  were  consumed  in  the 
verification  of  footings  and  postings,  and  one  week  for  the  rest  of 
the  audit.  There  can  be  no  hard-and-fast  rule  as  to  the  time  each 
class  of  work  should  take,  and  it  is  not  worth  while  to  attempt  to 
approximate  one.  Unless  there  is  justification  for  doing  other- 
wise, it  is  far  better  to  spend  not  over  one  week  on  postings  and 
footings,  and  three  weeks  on  work  which  afterwards  means  some- 
thing to  the  clients. 

The  questions  arise:  Is  it  not  possible  that,  in  thus  cutting 
down  the  work  by  two-thirds,  too  much  is  taken  for  granted? 
Is  an  auditor  excused  who  neglects  such  a  material  part  of  the 
work  as  that  of  verifying  the  footings  and  postings?    The  second 

VOL.  1—32 


498  AUDITING— GENERAL  PRINCIPLES 

question  is  answered  by  the  statement  that  no  auditor  can  be 
excused  who  neglects  any  part  of  the  work.  We  must,  however, 
be  sure  in  each  case  that  we  take  nothing  for  granted  until  we 
have  made  such  inteUigent  and  exhaustive  tests  as  assure  us  that 
the  accounts  as  a  whole  are,  in  our  judgment,  correct.  Note  the 
expression,  *'in  our  judgment";  for,  the  moment  you  deprive 
the  auditor  of  the  free  exercise  of  his  judgment,  you  reduce  him  to 
the  position  of  an  automaton,  and  the  title  of  professional  auditor 
then  becomes  a  misnomer.  What  constitutes  an  intelligent  and 
exhaustive  test  of  postings  and  footings?  In  seeking  an  answer, 
first  direct  attention  to  the  four  general  groups  into  which  they 
can  be  divided.  These  are:  (i)  the  records  of  the  purchase  of 
goods  or  materials  as  reflected  in  purchase  or  invoice  books, 
voucher  registers,  etc.;  (2)  the  records  of  sales  as  found  in  sales 
books  or  binders  or  in  any  other  of  the  various  good  and  bad 
forms  used;  (3)  the  receipt  of  cash;  (4)  the  payment  of  cash. 

The  majority  of  postings  and  footings  occur  in  connection 
with  the  records  mentioned,  so  that  if  we  can  agree  on  what 
constitutes  a  fair  test  of  these  groups  or  divisions,  we  can  safely 
leave  the  remaining  records  to  be  dealt  with  on  their  merits. 

The  following  suggestions  are  grounded  upon  the  fundamental 
principle  that  no  audit  is  complete  unless  the  trial  balances  of  all 
the  ledgers  have  been  proved.  There  may  be  exceptions  to  this 
principle  as,  for  instance,  in  case  of  a  department  store  in  which 
are  kept  one  hundred  individual  ledgers.  Here  an  exhaustive 
test  would  be  sufficient. 

I.  Purchase  Records 

If  fraud  exists  in  connection  with  purchases,  it  usually  is 
found  in  the  form  of  overcharges  or  fictitious  vendors.  Very 
seldom,  if  ever,  is  there  any  concealment  of  fraud  through  manip- 
ulations of  footings  or  postings.  The  auditor  does  not  seek  to 
locate  clerical  errors  in  trial  balances,  but  is  concerned  with  the 
possibility  of  the  trial  balance,  which  is  ostensibly  in  agreement 
with   the   books,   being  forced.     Since    this    occurs    not   only 


THE  DETAILED  AUDIT  499 

in  cases  where  fraud  exists,  but  also  where  there  is  a  lazy  or 
incompetent  bookkeeper,  the  auditor  should  always  be  on  the 
lookout  for  evidence  of  forced  balances.  As  a  rule,  however, 
when  a  trial  balance  is  forced  there  is  no  alteration  in  the  current 
postings  and  footings.  The  usual  and  popular  expedient  is  to 
transfer  in  the  ledger  the  last  posting  during  the  period  to  one  of 
the  large  nominal  accounts,  such  as  sales  or  expenses. 

These  remarks  on  the  trial  balance  concern  the  purchase 
records  in  that,  no  matter  what  other  detail  work  is  omitted,  the 
verification  of  the  postings  of  the  monthly  or  periodical  aggregates 
to  the  debit  side  of  the  purchase  accounts  must  not  be  forgotten. 
Usually  the  checking  of  the  credit  postings  can  be  omitted. 

If  the  concern  is  a  fairly  large  one  and  if  the  audit  covers  a 
period  of  one  year,  prove  the  footings  of  about  every  tenth  or 
twelfth  page  in  addition  to  the  last  page  of  each  month.  In  a 
smaller  concern,  prove,  say,  every  fifth  or  sixth  page,  including 
always  the  last  page  for  each  month.  It  is  difficult  to  imagine, 
and  wide  experience  has  not  developed,  a  case  where  such  a 
percentage  would  not  have  been  as  effective  in  any  given  audit  as 
•the  verification  of  the  footing  of  every  page.  That  is,  the  veri- 
fication of  every  page  did  not  disclose  any  discrepancies  (except 
as  hereafter  noted),  so  that,  naturally,  the  work  could  have  been 
cut  down  eleven-twelfths  with  equally  good  results  (except  as  to 
cost  to  the  client).  The  last  page  in  every  case  is  mentioned 
particularly,  because  instances  are  known  where  such  figures 
have  been  altered. 

2.  Sales  Records 

The  monthly  or  other  aggregates  of  the  sales  postings  should 
be  checked. 

There  is  more  fraud  in  connection  with  accounts  receivable  than 
any  other  department  of  a  business,  but  the  fraud  does  not  consist 
in  a  failure  to  post  to  the  ledgers  the  sales  which  are  recorded  in  the 
sales  books.  The  fraud  here  consists  in  entirely  omitting  the  sales 
from  the  sales  records  or  in  the  failure  to  enter  cash  collections. 


500  AUDITING— GENERAL  PRINCIPLES 

It  is,  however,  important  to  know  that  all  the  sales  appearing 
in  the  sales  record  have  been  posted.  As  stated  above,  this  can 
be,  and  should  be,  covered  by  use  of  a  controlling  account,  since 
the  items  are  of  such  a  nature  that  they  are  grouped  in  the  original 
records,  and  if  the  posting  of  a  thousand  entries  can  be  proved 
by  one  operation,  time  is  saved.  This  method  is  based  on  the 
assumption  of  course,  that  there  is  a  verified  trial  balance  of 
the  customers  ledgers  to  support  the  controlling  account.  The 
question  of  accounts  which  have  been  collected,  but  are  not  so 
shown,  will  be  considered  later. 

The  verification  of  the  footings  in  case  of  sales  records  is  some- 
what more  important  than  in  case  of  purchase  records.  In  a 
large  concern,  prove,  say,  every  eighth  page,  and  in  a  small 
concern,  say,  every  third  or  fourth  page,  always  including  the 
last  and  sometimes  the  next  to  the  last  page  of  each  month. 

Controlling  Account. — If  there  is  a  controlling  account 
with  customers  in  the  general  ledger,  it  is  not  necessary  to  verify 
in  detail  the  postings  of  the  customers  ledgers.  If  there  is  no 
controlling  account,  the  auditor  should  construct  one,  so  in 
neither  case  is  it  worth  while  to  prove  the  debit  postings. 

The  controlling  account  is  a  compilation  of  the  aggregates  of 
the  postings  to  the  individual  customers'  accounts.  They  may  be 
classified  as  follows : 


Debits 
Total  of  opening  balances,  as  per  last 

trial  balance 
Sales 
Protested  or  returned  cheques,  notes, 

etc. 
Interest,  etc. 


Credits 

Cash 

Discounts 

Returns  and  Allowances 

Notes 

Accounts  charged  off,  etc. 

Total  of  closing  balances 


In  some  sets  of  books  it  may  take  as  much  work  to  construct 
the  controlling  account  as  to  verify  every  posting;  but  even  so, 
the  time  spent  in  the  preparation  of  the  account  is  not  lost, 


THE  DETAILED  AUDIT  501 

because  the  data  thus  secured  is  useful  in  stating  the  results  of 
the  business. 

3.  Cheques  Received  Must  Be  Deposited 

Where  the  capital  stock  of  corporations  is  all,  or  nearly  all, 
owned  by  its  officers  or  directors,  they  frequently  handle  the 
funds  of  the  corporation  as  if  no  corporate  responsibility  exists. 
Usually  they  act  honestly  and  no  harm  is  done;  but  an  auditor 
cannot  afford  to  pass  over  illegal  acts  which  come  to  his  knowl- 
edge, even  though,  so  far  as  can  be  foreseen,  no  one  will  be 
injured  thereby. 

If  an  officer  uses  cheques  drawn  to  the  order  of  the  corpo- 
ration for  private  purposes  the  practice  cannot  be  condemned 
too  severely,  and  yet  it  is  not  uncommon.  All  cheques  received 
should  be  deposited.  The  officer  can  withdraw  such  sum  as  the 
corporation  owes  him. 

In  a  New  York  case,  decided  by  the  Court  of  Appeals  in  1908 
in  which  the  president  of  a  corporation  (all  the  stock  of  which  was 
owned  by  himself  and  the  secretary-treasurer)  used  a  cheque 
drawn  to  the  order  of  the  corporation  and  indorsed  by  it  to  pay  his 
personal  debt,  the  creditors  of  the  corporation,  upon  its  being 
declared  insolvent,  compelled  the  trust  company  that  cashed  the 
cheque  to  refund  the  money. ' 

In  a  case  which  the  author's  firm  investigated  recently,  an 
employee  had  charge  of  a  small  fund  created  for  the  purpose  of 
having  cash  on  hand  for  change  and  for  cashing  small  cheques  in 
an  emergency.  He  also  received  certain  cash  receipts  which 
should  have  been  deposited  each  day  so  that  only  the  original 
fund  would  be  retained.  No  check  was  kept  on  his  activities 
so  that  a  much  larger  sum  than  had  been  contemplated 
was  in  his  control.  An  officer  of  the  institution  being  in 
financial  difficulties  persuaded  the  employee  first  mentioned 
to  cash  his  personal  cheques  out  of  this  fund  and  to  hold  the 
cheques  so  cashed  undeposited.    This  continued  for  a  period  of 

^  Ward  V.  City  Trust  Company  of  New  York,  192  N.  Y.  61. 


502  AUDITING— GENERAL  PRINCIPLES 

ten  months,  when  upon  an  investigation  being  made  of  the 
officer's  activities,  it  was  found  that  he  had  received  from  the 
employee  in  this  way  almost  three  times  the  amount  which  should 
have  been  in  the  fund  at  any  one  time.  This  irregularity  could 
not  have  occurred  if  the  employee  had  been  required  to  deposit 
his  receipts,  including  the  officer's  cheques,  daily. 

The  same  officer  was  designated  with  his  superior  to  sign 
the  corporation's  cheques.  Both  names  had  to  appear  on 
the  cheques  to  make  them  valid.  The  superior,  upon  being 
called  away  on  business,  signed  a  number  of  cheques  in 
blank  and  left  them  with  his  subordinate  for  use  in  case  of 
emergency.  The  officer  affixed  his  signature,  made  the  cheques 
payable  to  the  corporation,  and  indorsed  them  as  an  officer, 
securing  the  cash  from  the  bank.  If  all  cheques  to  the  order  of 
the  corporation  had  been  deposited  to  the  corporation's  account, 
this  defalcation  could  not  have  occurred.  In  the  author's  opin- 
ion the  bank  paying  these  cheques  was  guilty  of  gross  negligence, 
because  inquiry  was  not  made  regarding  the  inconsistency  of 
requiring  two  signatures  to  be  attached  to  the  face  of  the  cheques 
which  indicated  that  funds  were  not  to  be  withdrawn  under  one 
signature,  whereas  the  indorsement  by  one  officer  on  cheques 
drawn  to  the  corporation's  order  was  precisely  the  same  thing, 
and  the  assumed  safeguard  of  two  signatures  was  lost.  Two 
signatures  often  fail  as  safeguards,  but  banks  cannot  ignore  the 
provision.  If  the  cheques  had  been  drawn  to  the  personal  order 
of  the  officer  ostensibly  for  pay-rolls  or  similar  purposes,  the  bank 
probably  would  not  have  been  liable. 

4.  Periodical  Verification  of  Bank  Balances 

The  auditor  should  ascertain  by  personal  investigation 
whether  the  bank  balances  have  been  verified  at  frequent  inter- 
vals throughout  the  period  covered  by  the  audit.  It  frequently 
happens  that  clerks  are  careless  about  reconciling  the  bank 
balances  with  those  shown  by  the  books.  In  some  cases  the 
pass-books  are  not  left  for  settlement  during  intervals  of  many 


THE  DETAILED  AUDIT  5^3 

months;  in  other  cases  the  pass-books  are  balanced  by  the  banks 
and  delivered  to  the  depositors,  but  are  not  verified  by  the 
latter. 

The  necessity  of  verifying  bank  statements  immediately 
after  their  receipt  from  the  bank  is  illustrated  by  a  case,  the 
facts  of  which  were  as  follows :  An  officer  of  a  corporation,  whose 
duty  it  was  to  deposit  certain  cash  receipts,  made  it  a  practice  to 
pocket  the  cash  and  substitute  his  own  personal  cheque.  In  this 
way  over  a  period  of  three  months  he  deposited  cheques  sub- 
sequently returned  as  worthless,  amounting  to  almost  $i  ,000.  If 
the  bank  statement  for  the  first  of  these  three  months  had  been 
verified  immediately,  the  irregularity  would  have  been  disclosed, 
and  it  would  have  been  almost  impossible  for  it  to  have  been 
repeated  as  it  was. 

The  same  officer  was  given  a  fund  of  $5,000  to  be  deposited 
in  his  name  as  a  fiscal  officer,  for  the  purpose  of  cashing  the  salary 
cheques  of  employees.  On  the  days  payments  were  to  be  made, 
he  was  supposed  to  withdraw  from  the  account  a  sum  sufficient 
to  cash  all  cheques ;  later  in  the  day  he  would  deposit  the  cheques 
so  cashed,  thus  restoring  the  account  to  its  original  condition. 
He  embezzled  the  entire  fund,  leaving  with  the  bank  only  a  few 
dollars  which  had  been  credited  as  interest.  For  several  months 
he  was  able  to  avoid  detection  and  at  the  same  time  accommodate 
the  employees  by  the  following  methods :  On  the  days  payments 
were  to  be  made,  he  would  present  to  the  bank  a  cheque  for  the 
amount  he  needed,  at  the  same  time  requesting  the  teller  to  hold 
the  cheque  until  late  in  the  day.  With  the  money  so  secured  he 
would  cash  the  employees'  cheques  and  later  in  the  day  deposit 
the  cheques  so  cashed.  The  teller  would  then  charge  the  account 
with  the  withdrawal  which  had  been  made  in  the  morning.  Of 
course,  the  suspicions  of  the  bank  teller  should  have  been  aroused 
and,  had  he^not  been  negligent  in  agreeing  to  hold  the  officer's 
cheque,  the  irregularity  would  have  been  discovered.  But  if 
the  bank  statement  had  been  examined  by  anyone  other  than 
the  officer  guilty  of  the  defalcation,  it  would  have  at  once  been 


504  AUDITING— GENERAL  PRINCIPLES 

apparent  that  the  account  contained  only  a  few  dollars  when  it 
should  have  contained  the  entire  fund  at  the  close  of  every 
banking  day. 

Monthly  Statements. — In  the  middle  and  far  West,  the 
banks  have  quite  generally  adopted  the  plan  of  sending  monthly 
statements  to  all  depositors,  accompanied  by  the  paid  cheques. 
This  practice  is  also  becoming  prevalent  on  the  part  of  the  banks 
in  the  East.  This  is  to  be  commended,  since  it  leads  naturally  to 
more  frequent  reconciliations  of  bank  balances. 

Prompt  Examination  of  Account. — The  bank  statements 
may  be  filed  away  without  examination  unless  someone  in 
authority  insists  on  prompt  attention.  Instances  have  been 
known  where,  junior  clerks  having  forged  signatures  to  cheques, 
the  fraud  was  not  discovered  for  a  long  time,  owing  to  carelessness 
in  inspecting  the  bank  settlements. 

The  law  is  that  the  writing  up  of  a  bank  pass-book,  with  a 
return  of  paid  cheques,  or  a  statement  of  account,  does  not  pre- 
clude an  ascertainment  of  the  true  state  of  the  accounts  if  cheques 
which  are  subsequently  discovered  to  be  forged  are  included  in 
the  balance.  But  if  the  depositor  is  required  by  the  usages  of 
business  or  otherwise  to  examine  the  account  within  a  reasonable 
time  and  to  give  timely  notice  of  any  objections  he  may  have, 
an  omission  to  perform  this  duty,  leaving  the  bank  to  rely  upon 
the  presumption  that  the  account  is  acquiesced  in,  whereby  it  is 
misled  to  its  prejudice,  makes  the  account  conclusive.  The  law 
is  not  unreasonable^  in  holding  that,  where  bank  settlements  lie 
around  untouched  for  long  periods,  those  in  control  of  the  busi- 


2  In  Morgan  V.  United  States  Mortgage  and  Trust  Co.,  208  N.  Y.  218;  loi 
N.E.  871,  the  court  said: 

"The  paid  checks  which  are  returned  are  the  vouchers  of  the  bank  for  its 
account  as  written  on  the  pass-book,  and  if  they  are  to  be  made  the  medium  of 
comparison  of  accounts  the  depositor  at  least  ought  to  endeavor  to  know 
that  they  tally  with  the  pass-book.  Otherwise  he  has  made  no  reliable  com- 
parison or  verification.  Therefore,  it  seems  to  me,  that  when  the  appellants 
relied  for  verification  merely  on  a  comparison  of  vouchers  without  any  effort  to 
verify  these  by  comparison  with  the  check  list  or  pass-book  they  did  not  exer- 
cise reasonable  methods.' 


THE  DETAILED  AUDIT  505 

ness  should  know  that  a  risk  is  being  run  for  which  there  is  no 
valid  excuse. 

Delayed  Credit  of  Deposits  by  Bank. — When  verifying  the 
bank  accounts  as  at  the  date  of  the  balance  sheet,  it  is  recognized 
that  deposits  entered  in  the  client's  books  on  the  last  day  of  the 
period  as  having  been  made  on  that  day,  may  legitimately  be 
entered  by  the  banks  on  the  following  day.  Instances  are  known 
where  the  actual  credits  by  the  bank  were  made  long  afterwards, 
which  of  course  proved  that  they  were  not  made  as  indicated. 
When  there  is  an  item  entered  in  one  period  to  be  completed  in 
another,  follow  it  up  carefully  and  specifically,  not  generally. 

Negligence  or  Depositor. — In  a  late  decision  it  was  held 
that  the  depositor  could  not  recover  from  the  bank  for  loss 
through  forged  signatures  or  by  a  change  in  the  amount  of  a 
check,  because  the  court  considered  that  the  depositor  had  been 
negligent  and  had  made  the  operations  of  the  thief  fairly  safe  and 
easy.  It  was  brought  out  in  this  case  that  correct  entries  had 
been  made  in  the  original  cash  records  but  that  the  secondary 
cash  records  were  falsified.  The  testimony  of  the  accountant 
who  made  periodical  examinations  of  the  books,  to  the  effect  in 
substance  that  it  is  not  necessary  to  go  to  the  book  of  original 
entry  in  order  to  check  the  accuracy  of  the  second  entry,  was 
characterized  by  the  court  as  little  less  than  absurd.  The  court 
also  held  that  the  plaintiff  could  not  absolve  himself  of  his  duty 
by  delegating  the  duty  to  some  other  person  to  perform  and  that 
whatever  was  done  by  the  accountant  was  the  act  (for  the  purpose 
of  the  case)  of  the  plaintiff.  ^ 


3  In  First  National  Bank  of  Richmond  v.  Richmond  Electric  Co.,  56  S.E.  152 
(Va.),  the  court  said: 

"In  the  commission  of  a  forgery  the  employee  is  not  the  agent  of  his 
principal,  and  his  knowledge  cannot  be  imputed  to  the  principal.  But  after 
the  forged  checks  have  been  paid  and  returned  to  the  depositor  as  vouchers 
...  if  the  depositor  assigns  the  duty  of  examining  such  vouchers  and 
account  to  this  same  clerk,  who  has  had  an  opportunity  of  committing  a  fraud 
and  has  done  so,  then  such  employee  in  the  discharge  of  this  duty  is  the  agent 
of  the  depositor,  and  such  depositor  is  chargeable  with  his  agent's  knowledge  of 
the  fraud." 


506  AUDITING— GENERAL  PRINCIPLES 

When  it  is  realized  that  the  United  States  Supreme  Court  has 
held  that: 4 

The  drawee  (bank)  can  be  held  bound  only  to  know  the  signature  of  the 
depositor,  and  not  of  the  handwriting  of  the  body  of  the  check,  and  money 
paid  in  good  faith  and  without  negligence  on  an  altered  check  may  be 
recovered  by  the  bank, 

the  importance  of  the  reconciliation  of  the  bank  balances  as  soon 
as  the  statements  are  received  cannot  be  overemphasized. 

Examination  of  Indorsements. — Some  auditors  do  not 
consider  it  necessary  to  scrutinize  indorsements  on  paid  cheques 
when  reconciling  the  bank  balances,  on  the  theory  that  the 
auditor  is  not  famiHar  with  the  signatures  of  those  persons  who 
indorse  the  cheques  in  writing.  This  scrutiny  requires  httle 
more  time  than  a  proper  examination  of  the  cheques  would  take. 
In  addition,  it  serves  to  keep  the  auditor  on  the  alert  relative  to 
the  possibiHty  of  irregularities  through  the  names  of  payees.  In 
many  cases  banks  pay  cheques  which  have  not  been  indorsed  by 
the  payees.  Usually  no  loss  ensues,  but  the  absence  of  such 
indorsements  may  be  embarrassing  when  it  is  necessary  to  prove 
that  the  payees  received  the  proceeds  of  the  cheques. 

In  a  recent  case  an  employee,  the  head  of  the  insurance 
department  of  an  investment  company,  the  plaintiff,  forged  in- 
dorsements on  cheques  which  he  had  had  drawn  by  the  company. 
These  forgeries  continued  over  a  period  of  nineteen  months,  dur- 
ing which  time  the  bank  sent  the  depositor,  regularly  every  half 
month,  a  statement  of  the  account,  with  the  paid  cheques.  Im- 
mediately upon  discovering  the  forgeries,  the  depositor  notified 
the  bank  in  writing  of  that  fact  and  that  the  bank  would  be  held 
responsible.  In  an  action  by  the  investment  company  to  recover 
the  aggregate  of  the  cheques  paid  on  the  forged  indorsements,  the 
bank,  among  other  defenses,  asserted  that  the  plaintiff  was 
negligent  because  it  did  not  examine  more  carefully  the  paid 
cheques  as  they  were  returned,  and  discover  the  forgeries  sooner. 

"^  Espy  V.  Cincinnati  Bank,  i8  Wall  614. 


THE  DETAILED  AUDIT  5^7 

The  court  held  that  the  depositor  is  not  bound  to  examine  the 
indorsements  on  returned  cheques.  He  is  bound,  within  a  reason- 
able time,  to  ascertain  the  genuineness  of  the  cheques  themselves. 
Thus  the  California  court  made  a  distinction  between  the  duty 
to  examine  indorsements,  ordinarily  made  on  the  reverse  side  of 
a  cheque,  and  the  duty  to  examine  the  elements — the  signature  of 
the  drawer,  the  name  of  the  payee,  the  amount  and  the  date,  mak- 
ing up  the  body  of  the  cheque,  to  determine  forgeries  therein.  ^ 

Depositor  Must  Exercise  Reasonable  Care. — In  another 
case  it  was  said : 

The  law  of  these  cases  in  no  wise  conflicts  with  our  own  case  of  Barter 
V,  Mechs.'  Natl.  Bank,  63  N.  J.  Law  578  .  .  .for  it  is  apparent  that  the 
exercise  of  reasonable  care  and  diligence  in  the  examination  of  the  ac- 
counts and  vouchers  in  the  case  at  bar  would  have  discovered  the  errors 
and  entitled  the  bank  to  information  concerning  them.  .  .  .  Now,  in 
the  case  at  bar  there  is  testimony  showing  negligence  in  the  depositor 
which  raises  an  estoppel  against  it.    .    .    . 

It  was,  however,  laid  down  by  the  Supreme  Court  in  the  Pratt  case 
that,  the  bank  having  paid  the  cheque  (with  forged  indorsements),  it 
could  not  charge  the  amount  against  the  depositor,  unless  it  showed  a 
right  to  do  so  on  the  doctrine  of  estoppel  or  because  of  some  negligence 
chargeable  to  the  depositor.  This^is  sound.  It  is  in  line  with  the  decisions, 
and  we  approve  it.  ^ 

Negligence  of  Bank. — In  still  another  case  it  was  said : 

It  may  require  care  and  skill  upon  the  part  of  the  bank's  ofiicials  to 
detect  a  forgery,  and  if  it  is  shown  that,  in  the  exercise  of  care  and  skill, 
the  forgery  could  have  been  discovered  by  the  bank,  but  that  the  bank  was 
negligent  in  failing  to  exercise  such  care  and  skill,  then  neglect  upon  the 
part  of  the  depositor  to  examine  the  statement  and  cheques  does  not  pre- 
clude the  depositor's  recovery.  "^ 


s  Los  Angeles  Investment  Co.  v.  Home  Savings  Bank  of  Los  Angeles,  182  Pac. 
(Cal.)  293  (1919)-  . 

6  Pomonia  Building  and  Loan  Association  v.  West  Side  Trust  Co.  oj  Newark, 
108  Atl.  (N.  J.)  240.  The  case  of  National  Dredging  Co.  v.  President,  etc.,  of 
Farmers'  Bank  of  State  of  Delaware,  69  Atl.  607 ;  6  Pennevill's  Delaware  Reports 
580,  emphasizes  the  point  that  in  the  case  of  a  bank  having  paid  a  forged  cheque, 
the  loss  to  the  depositor  should,  in  no  event,  be  greater  than  that  caused  to 
the  bank  by  his  neglect  of  duty. 

7  Farrell  et  al  v.  First  Natl.  Bank  of  Philadelphia,  263  Fed.  778. 


508  AUDITING— GENERAL  PRINCIPLES 

The  various  court  decisions  cited  indicate  the  importance 
of  prompt  reconciliation  of  depositors'  accounts  with  the  bank 
statements  or  balanced  pass-books  and  examination  of  the  paid 
cheques  returned  by  the  bank.  Any  laxity  in  this  respect  by  a 
client's  staff  should  be  brought  to  the  client's  attention  by  the 
auditor. 

Verification  of  Differences. — When  reconciling  bank  bal- 
ances, the  auditor  should  not  overlook  the  necessity  of  verifying 
the  differences  making  up  the  reconcihation.  It  is  not  sufficient 
to  make  up  a  reconciliation  beginning  with  one  balance,  and 
listing  the  differences  required  to  arrive  at  the  other  balance.  The 
differences  should  be  investigated  in  order  to  decide  whether  the 
items  are  bona  fide  open  items,  and,  where  possible,  the  open 
items  should  be  verified  by  an  examination  of  later  entries  and 
confirmed  by  correspondence  or  otherwise.  It  is  particularly  to 
be  borne  in  mind  that  a  subsequent  entry  which  apparently  offsets 
an  item  entering  into  the  reconcilement  is  not  of  itself  necessarily 
a  conclusive  proof  of  the  correctness  of  the  item;  it  might  merely 
switch  the  item  into  some  other  account.  Each  such  offsetting 
or  adjusting  entry,  if  for  any  material  amount,  must  be  carefully 
examined  to  make  certain  that  it  is  a  proper  one. 

''Canceled"  Cheques. — In  a  stock-broker's  office  the 
cashier  drew  cheques  to  the  order  of  bearer,  had  them  signed  by  a 
partner,  diverted  the  proceeds  to  his  own  use,  and  destroyed  the 
cheques  when  returned  by  the  banks.  The  stubs  of  these  cheques 
were  marked  ''canceled."  To  make  the  reconciliation  of  the 
bank  pass-book  with  the  cheque  book  appear  to  be  in  order,  he 
understated  the  footings  of  outstanding  cheques  by  amounts 
equal  to  the  shortage  Here  the  auditor  would  have  discovered 
the  fraud  by  personally  balancing  the  bank  account  and  securing 
direct  confirmation  of  the  bank  balance.  He  also  would  have 
been  put  on  notice  by  the  absence  of  the  cheques  marked 
"canceled." 


THE  DETAILED  AUDIT  509 

Cheques  Not  Returned. — The  outstanding  cheques  listed 
to  reconcile  the  bank  balance  should  be  compared  with  the  actual 
cheques  returned  from  the  bank  at  a  later  date.  Those  which 
are  not  then  returned  should  be  specially  investigated.  The 
auditors  should  see  that  no  cheques  for  cash  purposes  are  drawn 
at  the  close  of  the  period  and  entered  in  the  next  period. 

Examination  of  Statement  or  Pass-Book. — Unless  there 
is  some  special  reason  for  so  doing,  the  auditor  need  not  verify 
the  detailed  statement  or  pass-book  wherein  are  listed  in  detail 
the  cheques  paid  by  the  bank.  Particularly  is  this  so  when  the 
auditor  is  able  to  secure  the  last  settlement  direct  from  the  bank, 
or  before  anyone  else  has  had  access  to  it.  If  fraud  exists  and 
the  signatures  to  cheques  have  been  forged,  or  if  cheques  have 
been  properly  signed  but  for  dishonest  purposes,  the  inspec- 
tion of  the  list  of  cheques  paid  by  the  bank  will  disclose  that 
certain  items  were  not  entered  on  the  regular  stubs,  and  fur- 
ther investigation  will  lead  to  the  discovery  of  the  fraudulent 
practice. 

It  is  evident,  however,  that  if  the  auditor  has  direct  con- 
firmation of  the  closing  balance  and  makes  the  verification  of 
deposits  and  cheques  referred  to  elsewhere  herein,  he  will  discover 
the  fraud,  unless  of  course  the  fraud  occurred  in  a  period  for  which 
the  cheques  were  returned  prior  to  time  of  audit. 

5.  Cash  Receipts 

In  well-regulated  concerns  all  cash  receipts  are  deposited  in 
bank,  and  all  payments,  therefore,  must  be  made  from  the  bank 
account.  This  almost  disposes  of  the  question  of  verifying  the 
footings  of  the  cash  book.  If  the  bank  account  is  proved  and  if 
the  cash  receipts  and  payments  are  traced  into  and  out  of  the 
bank,  it  is  logical  to  prove  the  footings  of  the  cash  book  auto- 
matically at  the  same  time.  If  this  does  not  seem  to  be  complete 
verification,  in  a  large  business,  the  proving  of  every  third  or 
fourth  page  will  be  an  adequate  check. 


510  AUDITING— GENERAL  PRINCIPLES 

When  Receipts  Are  Not  Deposited. — In  every  case,  how» 
ever,  where  there  is  any  possibihty  of  the  receipt  of  any  consider- 
able amount  of  currency  from  sales  over  the  counter,  and  where 
such  receipts  are  not  deposited  daily  in  gross,  there  are  oppor- 
tunities for  manipulation  not  possible  under  other  circumstances. 
Consequently,  the  auditor  must  be  specially  vigilant  in  looking 
for  fraud. 

In  one  case  the  cashier  failed,  from  time  to  time,  to  deposit 
a  portion  of  the  receipts  from  cash  sales,  although  the  correct 
amounts  thereof  were  entered  in  the  cash  book  daily.  About 
once  a  year  he  concealed  the  amount  embezzled  by  overstating 
payments  for  merchandise  purchases.  In  an  annual  audit,  made 
after  the  close  of  the  year,  it  is  difficult  to  detect  such  fraud 
except  by  comparing  every  cheque  issued  during  the  year  with 
the  cash  book,  or  by  examining  every  voucher,  because  it  is  not 
usual  to  attempt  to  verify  the  cash  book  balances  at  any  date 
other  than  the  closing  date.  Of  course,  if  that  had  been  done  here 
it  would  have  shown  that  the  cash  book  balance  was  composed  of 
a  certain  sum  in  bank  and  a  very  large  amount  *'on  hand."  The 
size  of  the  latter  would  have  excited  suspicion,  but  legal  proof 
could  hardly  be  found  to  sustain  a  claim  that  it  was  not  in  the 
cash  drawer  at  the  time. 

Tampering  with  Cash  Book. — In  many  small  concerns  the 
cashier  handles  the  receipts,  writes  up  the  cash  book,  and  makes 
the  deposits.  He  might  retain  a  portion  of  the  receipts,  force  the 
footings  of  the  column  to  agree  with  the  actual  deposit,  and  in- 
crease the  footings  of  the  discount  column.  The  cash  book  would 
then  balance  across,  the  cash  balance  would  agree  with  the 
amount  shown  by  the  pass-book,  and,  since  the  discount  column 
would  be  posted  in  total  by  the  bookkeeper,  the  ledger  would  be 
in  balance  without  any  falsification  being  made  therein.  If  there 
are  special  columns  provided  for  cash  sales  or  similar  earnings, 
the  footings  of  such  columns  can  be  reduced  by  the  amount  of 
the  shortage.    They  thus  afford  additional  facilities  for  covering 


THE  DETAILED  AUDIT  51 1 

up  the  amounts  taken.    If  this  possibihty  exists,  the  footings  of 
the  discount  and  similar  columns  should  be  verified. 

Nominal  Accounts. — The  postings  of  the  nominal  accounts 
should  usually  be  verified,  not  because  there  is  any  great  danger 
of  fraud  lurking  therein,  but  for  the  purpose  of  locating  any 
possible  posting  to  a  wrong  account.  For  instance,  it  frequently 
happens  that  part  of  a  plant  or  old  machinery  has  been  sold. 
Sometimes  such  items  are  posted  to  an  earning  account  instead 
of  to  a  capital  or  a  reserve  account.  These  postings  are,  as  a  rule, 
few  in  number  and  are  important  enough  to  be  verified  in  extenso. 

Postings  to  Customers'  Accounts. — The  totals  of  postings 
to  the  credit  of  customers'  accounts  should  be  proved  through 
the  customers'  controlling  account.  If  there  is  no  controlling 
account  and  if  one  cannot  be  constructed  readily,  a  fair  test 
should  be  made  of  the  individual  ledger  credits,  working,  of 
course,  from  the  ledger  back  to  the  cash  book  and  not  vice  versa. 
The  reason  for  this  is  obvious;  if  a  customer  has  been  credited 
with  an  amount  which  purports  to  have  been  posted  from  the 
cash  book,  but  which  as  a  matter  of  fact  is  not  entered  there  at 
all,  the  discrepancy  cannot  be  discovered  by  using  the  cash  book 
as  a  basis,  and  it  is  not  safe  to  depend  on  looking  through  the 
ledger  subsequently  to  see  that  all  items  are  ticked.  It  is  some- 
times suggested  that  the  chief  danger  in  such  practice  lies  in  the 
possibility  that  the  ledger  clerk  can,  if  the  work  is  not  finished  at 
a  sitting,  supply  the  tick  marks  himself.  There  is  not  much  basis 
for  this  fear,  but  it  is  foolish  needlessly  to  expose  one's  self  to  it. 

If  it  is  thought  wise  to  verify  the  individual  postings  to  the 
customers'  accounts,  do  not  check  every  one  unless  some  very 
good  ground  for  suspicion  exists.  If  the  audit  is  a  periodical  one, 
say,  for  six  months,  cover  about  half  the  letters  of  the  alphabet  at 
one  time.  Six  months  later  cover  the  other  half;  or  cover  one- 
fourth  only  at  each  audit,  and  take  two  years  to  the  entire  list. 
Not  infrequently,  in  case  of  fraud  ledger  credits  do  not  appear 


512  AUDITING— GENERAL  PRINCIPLES 

correspondingly  as  cash  debits,  but  it  is  hard  to  imagine  a  case 
where  a  good  test  would  not  disclose  the  fraud.  Very  few  men 
confine  their  peculations  to  customers  whose  names  commence 
with  X  Y  Z.  The  auditor  can  afford  to  assume  that  the  defaulter 
will  inadvertently  manipulate  the  account  of  an  A  customer,  in 
which  case  he  will  be  detected  the  first  time,  while  if  he  uses  only 
one  or  two  letters,  he  will  still  be  detected  in  a  reasonable  time. 

6.  Cash  Payments 

On  the  payments  side  of  the  cash  book  it  is  also  possible  to 
cover  fraud  by  erroneous  footings.  In  most  cash  books  there  are 
special  columns  for  different  classes  of  expenses  which  are  posted 
in  total  at  the  end  of  the  month.  If  the  cashier  were  to  take  an 
unnumbered  cheque  from  the  back  of  the  book,  or  one  of  a  style 
similar  to  those  in  current  use,  and  have  it  drawn  to  his  order  or  to 
some  name  representing  himself,  but  does  not  enter  the  amount 
in  the  cash  book,  the  footings  could  be  falsified  to  that  extent. 
The  cheque  could  be  numbered  to  correspond  with  those  in  use 
at  the  time.  When  the  bank  settlement  is  received  and  the 
balance  verified,  the  cheque  could  be  destroyed. 

Accounting  for  Cheques. — Every  cheque  forming  part  of 
a  series,  or  bearing  any  distinguishing  mark  connecting  it  with 
the  concern  under  audit,  should  be  accounted  for.  If  spoiled,  the 
half  containing  the  serial  number  or  other  identifying  mark 
should  be  preserved  and  pasted  on  the  stub.  Cheques  should 
never  be  removed  from  the  back  of  a  book,  but  if  they  are,  for 
some  special  reason,  they  should  be  accounted  for. 

Frequently  these  precautions  are  not  enforced,  due  to  ignor- 
ance or  carelessness.  In  such  cases  the  auditor  should  report 
thereon  and  suggest  an  immediate  change  relative  thereto.  If 
in  subsequent  audits  no  improvement  is  found,  more  severe 
criticism  will  be  in  order. 

It  is  not  easy  to  secure  blank  cheques  bearing  the  name  of  a 
concern.     For  this  reason  hundreds  of  cases  of  fraud  occur 


THE  DETAILED  AUDIT  513 

through  the  improper  use  of  cheques  taken  from  the  backs  of 
books  or  from  the  front  in  their  regular  order.  The  stub,  in  these 
cases,  indicates  that  the  cheque  was  spoiled  and  destroyed. 

Sometimes  cheques  are  marked  ''void"  on  the  stubs  and  the 
two  halves  of  one  cheque  are  pasted  on  two  stubs  (one  of  the 
portions,  of  course,  being  without  a  number),  thus  providing  a 
cheque  which  is  used  by  the  cashier  to  obtain  money  fraudulently. 

These  manipulations  are  not  likely  to  occur  more  than  once 
in  an  auditor's  experience,  but  all  of  the  possibilities  mentioned 
are  based  on  actual  experience,  so  that  an  auditor  cannot  afford  to 
neglect  all  reasonable  precautions  to  ascertain  if  such  fraud  exists. 

All  Payments  by  Cheque. — The  auditor  should  insist, 
wherever  feasible,  on  having  all  payments  represented  by 
cheques.  This  reduces  the  possibility  of  manipulation  of  cash 
book  footings  to  a  minimum,  and  for  this  reason  alone  it  is  worth 
the  trouble  of  depositing  all  currency  receipts.  If  the  footings 
cannot  be  proved  by  the  bank  account,  verify,  say,  every  third 
or  fourth  page. 

Verifying  Postings. — If  the  cash  book  is  properly  columned 
and  if  a  controlling  account  is  kept  with  accounts  payable,  most 
of  the  postings  then  consist  of  monthly  aggregates,  which  should 
be  checked  to  see  that  they  are  not  posted  into  the  wrong  ledger 
account.  Here,  however,  it  is  important  to  avoid  duplication. 
In  many  audits  it  is  desirable  to  make  full  analyses  of  the  various 
expense  and  purchase  accounts  for  use  in  the  reports.  If  feasible 
and  convenient,  this  work  should  be  done  when  postings  are 
verified,  as  it  obviates  a  second  reference  to  the  cash  book  pages 
if  the  details  in  the  ledger  are  not  sufficient. 

Postings  to  the  individual  accounts  need  not  be  verified  except 
for  some  special  reason.  The  payments  are  supposed  to  be 
vouched  to  establish  their  authenticity,  so  it  is  not  necessary  to 
trace  the  payments  to  the  debits  of  the  accounts.  A  controlling 
account  supported  by  a  trial  balance  of  the  subsidiary  ledger  is  a 

VOL.  1—33 


SH  AUDITING— GENERAL  PRINCIPLES 

good  proof,  but,  even  if  this  is  not  in  evidence,  the  checking  of  the 
debit  postings  is  usually  superfluous  work. 

Summary. — ^As  against  the  practice — fairly  common — of 
checking  all  postings  and  footings,  the  above  course  may  seem 
radical.  It  is  not  radical,  however,  if  it  is  approved  after  full  dis- 
cussion and  thought,  and  if  it  stands  the  additional  test  of  each  par- 
ticular audit.  Where  the  slightest  cause  for  suspicion  exists,  there 
must  be  a  careful  study  of  every  phase  of  the  situation.  Even  if 
suspicion  has  been  aroused  and  there  is  a  probabiHty  that  some- 
thing is  wrong,  the  most  f  ooHsh  thing  an  auditor  can  do  is  to  jump  in 
blindly  and  tick  every  entry  in  the  books.  This  has  been  done  more 
than  once,  but  the  practice  cannot  be  condemned  too  strongly. 

7.  Other  Records 

In  many  lines  of  business  the  books  of  account  bear  distinctive 
titles.  Perhaps  in  the  foregoing  pages  these  books  are  not  called 
by  their  technical  names.  For  instance,  in  a  magazine  publishing 
business  a  sales  book,  so  called,  may  not  be  found,  but  a  subscrip- 
tion record  and  an  advertising  register  are  usually  kept. 

With  these  books,  as  to  footings  and  postings,  about  the  same 
procedure  should  be  followed  as  with  a  regulation  sales  book — 
as  a  matter  of  fact,  that  is  exactly  what  these  two  records  repre- 
sent— sales  of  advertising  space  and  sales  of  copies  of  the  publica- 
tion for  a  stated  period  (subscriptions).  It  is  far  more  satisfac- 
tory to  have  an  illuminating  title  like  this  for  a  book  than  to 
attempt  to  cut  down  the  number  of  account  books  in  use  and 
perhaps  journalize  every  transaction.  In  addition  to  the  saving 
of  labor  to  a  bookkeeper  through  the  use  of  books  for  special 
purposes,  the  more  important  function  is  performed  of  keeping 
the  records  clear  for  one  who  does  not  understand  bookkeeping. 
Most  business  men  are  at  sea  when  they  try  to  understand  an 
ordinary  journal,  but  if  a  book  is  labeled  ''subscription  record," 
or  "advertising  register,"  anyone  with  ordinary  intelligence 
knows  exactly  what  to  look  for  within  its  pages. 


CHAPTER   XXIV 

THE  DETAILED  AUDIT— VERIFICATION  OF  INCOME 

Accurate  data  is  not  available  from  which  a  dependable 
analysis  of  frauds  could  be  compiled;  nevertheless  an  estimate 
prepared  from  long  experience  is  that  nearly,  if  not  quite,  75  per 
cent  of  all  defalcations  and  frauds  are  connected  directly  with  a 
failure  to  account  for  income  or  cash  receipts,  whereas  less  than 
25  per  cent  of  them  take  the  form  of  diversion  of  cash  after  it  has 
found  its  way  into  the  treasury. 

Fraud  Connected  with  Receipts 

We  shall  discuss  the  former  type  of  fraud  because  it  is  more 
important.  This,  in  turn,  can  be  divided  into  two  groups.  The 
first  group  embraces  that  class  of  frauds  which  is  characterized 
by  the  failure  to  enter  in  the  books,  or  at  least  in  the  books  which 
form  a  part  of  the  double-entry  system,  any  record  whatever 
of  the  sale  or  delivery  of  goods  or  materials.  The  second  class 
includes  those  cases  in  which  a  record  of  the  original  sale  or  de- 
livery appears,  but  where  the  subsequent  collection  is  omitted 
entirely  or  where  the  entry  of  collection  is  postponed  until  a  later 
date.  Obviously,  the  former  methods  are  the  ones  most  easily 
concealed.  The  auditor  must  therefore  be  especially  vigilant  in 
this  part  of  the  audit. 

The  auditor  should  secure  a  list  of  all  books  in  use.  This  list 
should  include  not  only  the  books  which  comprise  the  double- 
entry  system,  but  also  all  those  usually  termed  ''memorandum" 
books,  which  contain  original  data,  and  from  which  the  formal 
entries  are  compiled. 

When  the  audit  is  completed  the  auditor  should  be  able  to 
certify  that,  in  his  opinion,  all  revenue  or  earnings  have  been 
properly  accounted  for.     This  does  not  mean  that  the  cash  which 

515 


5l6  AUDITING— GENERAL  PRINCIPLES 

was  duly  entered  in  the  cash  book,  and  the  sales  which  were  in 
due  course  entered  in  the  sales  records,  are  assumed  to  be  all  the 
cash  receipts  and  all  the  sales  without  further  investigation. 

A  careful  inquiry  should  be  made,  or  personal  watch  kept,  to 
see  who  opens  the  mail,  and  what  record,  if  any,  is  made  by  such 
person.  The  record,  if  a  ''memorandum"  one,  should  be  com- 
pared (in  part)  with  the  formal  books. 

SALES 

The  chief  point  of  importance  in  the  verification  of  sales  is 
the  gross  amount  of  possible  income;  that  which  the  auditor  finds 
properly  recorded  in  the  books  may  be  only  part  of  the  entire 
income.  It  is  necessary  to  ascertain  if  any  transactions  have 
been  omitted  from  the  books. 

Importance  of  Original  Records 

As  a  rule,  some  sort  of  record  exists  which  can  be  compared 
with  the  cash  book.  The  formal  original  records,  which  are 
nicely  written  up  and  which  agree  exactly  with  the  other  books, 
are  not  the  ones  the  auditor  wants.  If  he  can  find  the  first 
''originals,"  in  rough  form  perhaps,  and  very  dirty  and  almost 
illegible,  he  should  use  such  records  in  preference  to  the  fair 
copies,  because  the  latter  are  frequently  written  up  by  the  same 
men  who  write  up  the  final  cash  records.  Professional  auditors 
agree  that  original  records  of  this  type  reveal  to  them  perhaps 
more  instances  of  fraud  than  does  any  other  source  of  information. 
Their  importance  for  this  purpose  cannot,  therefore,  be  over- 
estimated. 

Memorandum  Books  to  Be  Used. — The  list  of  memoran- 
dum books  required  by  the  auditor  should  include  the  original 
records  of  sales  and  the  original  records  of  shipments.  Rarely 
are  the  order  books  or  shipment  or  delivery  books  considered  as 
formal  books  of  account.  Perhaps  it  is  fortunate  for  the  auditor 
that  this  is  so,  because  in  many  cases  where  the  examination  of 


THE  DETAILED  AUDIT  517 

these  records  has  revealed  fraud,  great  astonishment  and  usually 
indignation  have  been  expressed  that  an  auditor  should  ask  to 
see  ''memorandum"  books.  In  most  of  these  cases,  had  the  de- 
faulters suspected  that  the  books  mentioned  would  be  called  for, 
they  could  readily  have  destroyed  or  altered  them  before  the 
examination  occurred. 

Cash  Sales. — It  is  important  to  ascertain  that  all  cash  sales 
are  accounted  for.  In  nearly  every  business  some  sales  are  col- 
lected for  at  once  and  are  not  passed  through  the  customers 
ledgers.  If  the  general  ledger  shows  few  such  transactions,  this 
should  not  influence  the  auditor  unless  he  has  made  inquiry  from 
someone  other  than  the  cashier.  In  one  instance  the  auditor 
found  that  practically  no  cash  sales  were  accounted  for.  He 
inquired  into  this  and  was  informed  that  it  was  not  the  custom 
to  make  such  sales.  Further  investigation,  however,  developed 
the  fact  that  the  cash  sales  had  been  quite  large,  but  that  his  first 
informant  had  pocketed  the  whole  proceeds.  In  this  case  a 
rough  memorandum  was  discovered  which  enabled  the  auditor  to 
locate  the  entire  shortage. 

Tests  eor  Sales. — It  is  the  auditor's  duty  to  verify  the  in- 
come from  sales  as  evidenced  by  the  records  or  papers  covering 
the  transactions  from  the  time  an  order  is  received  until  the  goods 
are  delivered.  Wherever  possible,  therefore,  he  should  secure  the 
order  books  and  compare  some  of  them  with  the  ledgers  to  see  that 
the  orders  were  filled.  If  not,  why  not?  It  may  be  that  through 
carelessness  an  order  was  not  filled  and  that  it  was  not  reported. 
Here  is  a  good  chance  to  be  of  positive  value  to  the  client. 

Orders  may  have  been  filled  and  the  proceeds  collected  but 
not  accounted  for.  This  should  be  discovered  by  comparing  the 
shipping  or  delivery  books  with  the  sales  records.  Tests  here 
are  all  that  are  necessary,  because  any  system  of  fraud  in  this 
channel  has  been,  in  practically  all  known  cases,  continuous,  so 
that  a  complete  comparison  for  a  few  weeks  or  a  month  covers 
the  point  quite  as  well  as  a  more  exhaustive  comparison. 


5I8  AUDITING— GENERAL  PRINCIPLES 

While  examining  the  sales  book  or  original  record,  the  auditor 
should  satisfy  himself  that  items  representing  shipments  after 
the  close  of  the  period  are  not  included  prior  thereto. 

Trial  Balance  as  an  Aid. — A  fruitful  source  of  inspiration, 
in  the  effort  to  ascertain  whether  or  not  all  the  income  has  been 
accounted  for,  is  the  balance  sheet — or  the  trial  balance  after 
closing,  which  may  state  the  various  items  of  assets  in  greater 
detail  than  the  balance  sheet.  Proper  thought  should  be  de- 
voted to  each  item  to  determine  the  possibility  of  the  income 
therefrom  being  omitted  from  the  books.  For  instance,  a  min- 
ing company's  balance  sheet  may  show  that  it  owns  workmen's 
houses.  The  auditor  must  then  find  out  if  all  of  the  rents  of  all 
the  houses  have  been  accounted  for.  Furthermore,  where  there 
are  tenants  he  usually  finds  that  sales  of  coal  or  other  fuel  and 
all  sorts  of  supplies  have  been  made  to  them.  If  he  does  not  find 
any  record  of  such  sales,  he  should  inquire  why  from  someone 
*' higher  up."     He  should  not  take  the  cashier's  word  for  it. 

These  comments  are  merely  suggestive  and  serve  to  illustrate 
the  idea  that  the  auditor  must  not  use  the  receipt  side  of  the 
cash  book  as  a  complete  basis  for  verifying  the  actual  income  or 
receipts.  He  must  work  from  every  outside  source  he  can  find 
to  the  cash  book.     He  will  then  be  reasonably  safe. 

When  Collections  Are  Not  Accounted  For. — There  is 
not  the  same  difficulty  with  those  cases  in  which  there  is  some 
record  of  a  sale,  in  one  of  the  original  books  of  account,  of  which 
the  subsequent  collection  of  the  proceeds  has  not  been  accounted 
for,  or  in  which,  although  the  sales  have  been  debited  in  due 
course  to  customers,  the  collections  have  not  been  credited. 

The  former  class  can  be  disclosed  by  a  good  test  of  the  foot- 
ings of  the  sales  records  and  by  proving  the  postings  of  same  to 
the  customers  ledgers.  This  has  been  fully  covered.  The  in- 
stances in  which  credits  have  been  arbitrarily  made  to  customers' 
accounts,  but  without  corresponding  entry  in  the  cash  book, 
have  also  been  covered. 


THE  DETAILED  AUDIT  519 

Orders  for  Future  Delivery 

The  auditor  should  investigate  the  orders  for  future  delivery 
and  make  comparisons  with  such  orders  at  the  close  of  the  pre- 
vious year.  Should  there  be  a  radical  change  in  the  volume  of 
these  orders,  or  should  the  bulk  of  the  orders  not  be  for  immediate 
delivery,  attention  should  be  called  to  this  fact  in  the  report. 

Consignments  and  Goods  Out  on  "  Memorandum  " 

Since  carelessness  is  apt  to  exist  in  connection  with  all  trans- 
actions which  are  out  of  the  regular  routine,  the  auditor  should 
carefully  inspect  the  records  relating  to  charging  out,  keeping 
track  of  and  collecting  the  proceeds  of  goods  sent  out  on  ''memo- 
randum "  or  ''on  sale."   These  are  trade  terms  for  consignments. 

If  not  charged  to  the  regular  ledger  account  of  the  consignee 
(which  may  be  inadvisable),  the  record  of  outstandings  should 
be  kept  in  a  substantial  loose-leaf  binder  equal  in  form  and 
dignity  to  the  ordinary  customers  ledgers. 

It  is  necessary  to  create  an  impression  of  permanence  about 
the  records  in  an  office,  or  else  the  data  which  are  considered  to 
be  temporary  will  be  kept  in  an  unsatisfactory  and  careless 
manner. 

The  record  should  be  looked  upon  as  a  running  account. 
All  freights,  drayages,  insurance,  and  other  charges  should  be 
posted  thereto  as  incurred.  In  support  of  the  memorandum  or 
temporary  records  in  use,  the  auditor  should  be  furnished  with 
evidence  that  the  terms  and  conditions  are  in  order.  Usually 
the  correspondence  relating  thereto  is  sufficient,  provided  it 
carries  the  authority  of  one  competent  to  fix  such  terms.  A 
careful  test  of  the  accounting  for  the  net  proceeds  as  shown  to  be 
due  by  the  record  just  described,  should  then  be  made.  If  the 
test  proves  that  no  loss  is  liable  to  have  occurred,  there  is  no 
necessity  for  a  complete  verification. 

If  consigned  goods  have  not  been  accounted  for  when  the 
books  are  closed,  the  consignee  should  be  asked  for  an  account 
current  up  to  the  date  of  closing.     Based  on  this,  credit  may  be 


520  AUDITING— GENERAL  PRINCIPLES 

taken  for  the  proceeds  of  sales  actually  made.  The  balance 
should  be  treated  as  stock-in-trade  and  valued  on  the  basis  de- 
scribed on  page  ii6  ^/  seq.  Goods  which  have  been  charged  out 
at  selling  prices  and  appear  as  accounts  receivable  must  likewise 
have  been  treated  as  stock-in-trade  and  the  valuation  adjusted 
to  the  proper  basis  for  balance  sheet  purposes. 

Goods  Received  for  Sale 

If  the  concern  under  audit  is  the  consignee,  the  accounts  should 
be  handled  differently.  If  the  goods  received  are  to  be  sold  on 
commission  for  account  of  the  consignor,  then  the  income  consists 
of  a  commission  on  the  selling  price,  or  perhaps  the  gross  amount 
realized  above  a  certain  fixed  price,  or  some  one  of  the  many 
other  understandings  upon  which  consignments  are  received. 

Contractual  Relations. — The  auditor  must  have  access  to 
the  exact  contract  between  the  parties  in  order  to  test  the  ac- 
curacy of  this  income.  In  many  cases  the  agreements  are  verbal 
or  are  based  on  correspondence  more  or  less  conflicting  as  to 
certain  terms.  Misunderstandings  frequently  arise  between 
the  consignor  and  the  consignee,  due  principally  to  the  failure  of 
the  minds  to  meet  before  the  contractual  relations  commence. 
The  auditor  usually  has  an  opportunity  to  urge  the  desirability 
of  entering  into  an  explicit  contract  at  the  outset  and  of  furnish- 
ing a  copy  to  the  client's  office,  so  that  the  terms  and  conditions 
of  each  consignment  may  be  noted  in  the  books.  If  a  consign- 
ment is  only  partially  disposed  of  when  the  books  are  closed,  care 
must  be  taken  that  the  unsold  goods  are  not  included  in  the  in- 
ventory. A  record  of  the  quantities  on  hand  should  be  made, 
but  the  values  should  be  entered  ''in  short"  and  a  memorandum 
made  to  the  effect  that  the  items  belong  to  the  consignor. 

Insurance. — Inquiry  should  be  made  as  to  whether  such 
goods  are  insured,  and  if  so,  in  whose  name.  If  in  the  name  of 
the  consignee,  the  policies  must  contain  a  stipulation  covering 
the  facts  of  title. 


THE  DETAILED  AUDIT  521 

Profits  on  Goods  Sold. — On  lots  partly  disposed  of,  credit 
may  be  taken  for  the  proportionate  commission  or  profit  on 
goods  sold  and  delivered,  but  no  income  should  be  taken  credit 
for  on  unsold  or  undelivered  goods.  In  order  to  satisfy  himself 
that  the  accounts  are  in  order,  the  auditor  should  request  that 
pro  forma  account  sales  be  made  up  for  all  open  consignments. 
The  quantities  not  yet  disposed  of  should  be  checked  with  the 
inventories  and  the  accrued  earnings  should  also  be  verified. 

Charges  to  Consignor. — The  account  sales  should  be  scruti- 
nized in  order  to  see  that  all  legitimate  charges  are  made  to  the 
consignor.  Commissions  and  freights  are  not  usually  forgotten, 
but  careless  clerks  do  not  always  include  insurance,  cartage, 
allowances,  and  similar  items  which  may  be  permissible.  Other 
items,  such  as  extra  charges  for  special  services,  postage,  etc., 
may  not  be  thought  of,  but  since  items  of  this  nature  are  charged 
by  some  commission  houses,  it  is  always  pertinent  to  inquire 
whether  the  matter  has  had  full  consideration. 

Sales  Not  Delivered 

In  closing  books  there  seems  to  be  a  temptation  on  the  part 
of  most  concerns  to  anticipate  all  profits  in  sight.  Therefore, 
if  sales  have  been  made  for  future  delivery,  the  tendency  is  to 
charge  the  goods  and  create  an  account  receivable  or  make 
some  adjustment  of  the  income  account  in  order  to  include  the 
profit  which  it  is  expected  will  be  realized.  Conservative  busi- 
ness men  follow  this  course  only  in  exceptional  cases,  and  when 
the  accounts  clearly  disclose  the  amount  of  profits  anticipated. 
In  a  going  business,  during  normal  times  no  adjustment  should 
be  made  of  orders  not  delivered. 

In  the  automobile  trade,  for  instance,  sales  are  effected  and 
substantial  deposits  or  part  payments  are  received  long  before 
the  cars  are  delivered.  But  no  profit  has  been  realized  nor 
may  ever  be  realized,  so  that  the  inclusion  of  this  hoped-for 
profit  in  an  income  account  is  absolutely  wrong.      Thousands 


522  AUDITING— GENERAL  PRINCIPLES 

of  such  sales  are  never  consummated  by  reason  of  the  failure 
of  the  factories  to  build  the  cars;  sales  are  canceled  and  the  de- 
posits returned,  and  none  of  the  expenses  incurred  thereby  are 
compensated  for. 

In  other  cases  the  goods  may  be  on  hand  or  in  process  of 
manufacture,  so  that  the  expectation  of  being  able  to  deliver  is 
based  on  a  sounder  hypothesis,  but  the  rule  is  precisely  the  same. 
No  profit  should  be  taken  until  a  delivery  or  a  tender  has  been 
made  and  the  sale  is  converted  into  a  valid  claim  against  a  solvent 
debtor,  except  when  special  circumstances,  such  as  general  prac- 
tice in  a  particular  industry,  justify  the  practice. 

Expenses  or  Future  Sales. — There  is  some  merit  in  the 
contention  that  if  sales  for  future  delivery  have  been  made,  and 
the  goods  are  on  hand  ready  to  ship,  the  goods  may  in  any  event 
be  inventoried  at  something  more  than  manufacturing  cost. 
That  is,  the  expenses  of  sale  having  been  incurred  to  this  extent, 
the  period  in  which  delivery  is  made  should  be  forced  to  bear  its 
share  of  the  burden,  and  such  expenses  should  be  carried  forward 
as  an  asset  under  the  caption  ''deferred  charges  to  operations." 
These  may  include  such  sales  expenses  as  commissions,  salaries, 
advertising  and  traveling  expenses,  etc.,  but  must  not  include  any 
part  of  fixed  charges  such  as  rent,  administration  expenses,  etc. 

Advances  and  Deposits. — If  part  of  the  sales  price  has  been 
collected  in  advance  or  deposits  have  been  received,  such  items 
should  be  separately  stated  on  the  balance  sheets,  because  they 
do  not  constitute  trade  liabilities,  but,  on  the  contrary,  are  evi- 
dences of  prospective  profits.  There  may  be  many  a  slip  be- 
tween the  order  and  the  profitable  closing  of  the  transaction,  as 
Judge  Clark  said  in  the  American  Malting  case:^ 

These  contracts  were  to  deliver  at  a  future  time  a  product  not  yet  made, 
from  raw  material,  not  yet  purchased,  with  the  aid  of  labor  not  yet  ex- 
pended.   The  price  agreed  to  be  paid  at  that  future  time  had  to  cover  all 


Hutchinson  v.  Curtiss  (1904),  92  N.  Y.  S.  70;  45  Misc.  Rep.  484. 


THE  DETAILED  AUDIT  523 

the  possible  contingencies  of  the  market  in  the  meanwhile  and  might  show 
a  profit,  and  ran  the  chance  of  showing  a  loss.  .  .  .  You  cannot  make  a 
dividend  of  a  hope  based  upon  an  expectation. 

Cash  Discounts 

The  auditor  should  secure  from  the  principals  an  authorita- 
tive statement  of  cash  discounts  allowed  to  customers.  With  this 
as  a  basis,  a  fairly  exhaustive  test  should  be  made  of  the  discount 
deductions  or  allowances  as  stated  in  the  cash  book.  In  rare 
cases  the  cash  book  shows  net  receipts  only,  in  which  event  dis- 
counts are  credited  through  an  allowance  book  or  journal;  but 
since  the  latter  method  involves  writing  customers'  names  twice, 
no  up-to-date  concern  permits  it.  The  discounts  should  appear 
in  a  column  on  the  receipt  side  of  the  cash  book,  next  to  the 
column  containing  the  gross  or  net  collections  from  customers. 

For  convenience  in  posting,  the  gross  amount  is  sometimes 
entered  in  the  "accounts  receivable""  column.  The  total  of  the 
discount  column  must  then  be  deducted  from  it  in  order  to  arrive 
at  the  cash  balance.  It  is  better  practice  to  enter  the  net  cash 
collection  in  one  column  and  the  amount  of  the  discount  in  the 
next.  In  posting,  the  two  amounts  should  be  entered  "  in 
short"  on  the  credit  side  of  the  customer's  account  and  the  gross 
amount  should  be  extended  to  the  money  column. 

Instances  are  known  in  which  cashiers  have  systematically 
overstated  the  discount  allowance,  either  by  increasing  the 
amount  actually  deducted  or  by  entering  a  discount  where  none 
was  claimed  or  allowed.  This  is  a  matter  to  which  little  atten- 
tion is  directed  in  an  establishment  in  which  the  work  of  cashier 
and  bookkeeper  is  performed  by  the  same  person,  or  in  which 
the  posting  clerks  are  mere  machines,  and  can  be  depended  upon 
to  overlook  fraud  of  this  nature.  In  view  of  this  probable  free- 
dom from  detection  and  the  numerous  frauds  which  have  thus 
occurred,  the  auditor  must  make  a  test  thorough  enough  to 
satisfy  himself  fully.  If  there  is  anything  wrong  it  is  likely  that 
it  will  appear  frequently,  so  that  the  test,  while  exhaustive  as  to 


524  AUDITING— GENERAL  PRINCIPLES 

the  period  covered,  need  extend  over  only  a  few  days  or  weeks, 
depending  on  the  volume  of  collections. 

Collections  Not  Accounted  For 

We  now  come  to  what  is  believed  to  be  the  most  prolific 
source  of  fraud  practiced,  viz.,  the  failure  to  enter  in  any  book 
the  collections  from  customers.  The  detection  of  such  fraud  is 
difficult.  Therefore  it  will  pay  to  devote  considerable  time  and 
space  to  the  subject. 

Illustrations. — The  most  common  irregularity  is  illustrated 
as  follows:  Customer  A,  on  January  2,  pays  $112.53,  say,  by 
cheque.  The  cashier  fails  to  enter  the  collection  in  his  books. 
If  he  has  made  other  collections  in  currency  exceeding  $112.53, 
he  deposits  the  cheque  and  takes  the  equivalent  in  currency  from 
the  drawer,  thus  obviating  the  necessity  of  forging  the  indorse- 
ment and  having  the  cheque  Cashed,  although  the  latter  method  is 
more  common  than  is  generally  supposed.  In  the  first  case  the 
fraud  can  be  discovered  by  comparing  the  details  of  the  cash 
receipts  with  the  details  of  the  bank  deposits  as  listed  in  the 
cheque  stubs  or  copy  books;  but  this  record  is  not  always  avail- 
able and,  moreover,  auditors  frequently  find  that  where  such  a 
fraudulent  practice  exists  the  record  of  the  bank  deposit  has  been 
altered  or  made  up  to  correspond  with  the  cash  book,  which 
makes  the  comparison  of  no  value.  In  one  instance  a  cashier 
borrowed  a  stamp  from  the  bank  and  stamped  some  deposit 
tickets  which  he  fraudulently  used.  It  is  always  dangerous  to 
accept  duplicate  deposit  tickets  as  final  evidence  of  money 
deposited  in  clients'  banks. 

In  most  such  cases  the  thief  does  not  consider  it  safe  to  hold 
out  collections  too  long  for  fear  that  somebody  in  the  office  will 
discover  that  customer  A  has  not  paid  and  so  try  to  collect  from 
him.  Therefore,  on  January  31,  he  decides  that  it  is  not  wise  to 
hold  up  A's  credit  any  longer.  He  accordingly  credits  him  with 
$112.53  ii^-  the  cash  book.     This  amount  finds  its  way  to  the 


THE  DETAILED  AUDIT  5^5 

ledger  in  due  course.  By  this  time  the  cashier  is  deeper  in 
trouble.  Customer  B  having,  on  January  31,  paid  $250  (also  by 
cheque),  the  cashier  fails  to  enter  the  amount  and  thus  creates 
a  cash  ''over"  of  $137.47,  which  he  removes  from  the  cash 
drawer  as  soon  as  he  can  accumulate  that  amount  of  currency. 
Here  again  is  urged  the  importance  of  recommending  to  clients 
the  daily  deposit  of  all  receipts — currency  and  cheques.  When 
this  is  done  there  is  far  less  opportunity  for  fraud  afforded  to  a 
clerk  dishonestly  inclined. 

So  it  continues.  The  defaulter  must  soon  credit  B  with  $250, 
and  he  therefore  calls  on  C's  account;  or,  by  this  time,  A  may 
have  paid  again.  Always  the  amount  grows  larger  and  larger 
until  in  many  cases  the  discovery  is  forced  without  the  aid  of  an 
outside  auditor.  Usually,  however,  it  goes  on  for  years.  Un- 
fortunately such  practice  has  more  than  once  been  in  full  force 
during,  prior  to,  and  subsequent  to,  periodical  audits  by  public 
accountants. 

Confirmations  of  Outstandings 

The  auditor  can  best  detect  such  defalcations  by  sending 
statements  to  all  customers,  requesting  them  to  confirm  the  ac- 
curacy of  the  balance  on  a  blank  inclosed  for  the  purpose,  which 
in  turn  is  to  be  returned  direct  to  the  auditor's  office.  This 
practice  is  followed  by  many  leading  auditors.  Therefore,  if 
the  client  does  not  or  will  not  consent  to  such  a  course,  the  re- 
sponsibility for  the  integrity  of  the  customers'  balances  is  squarely 
up  to  him.  The  objections  to  this  practice  grow  fewer  each  year. 
No  doubt  within  a  few  years  the  verification  of  customers'  out- 
standing balances  by  correspondence  with  the  auditor  will  be 
the  rule  rather  than  the  exception. 

The  old  form  was  substantially  as  follows : 

Dear  Sirs: 

In  making  our  periodical  audit  of  the  accounts  of 

we  desire  to  verify  the  accounts  receivable  by  direct  correspondence  with 


526 


AUDITING— GENERAL  PRINCIPLES 


each  customer,  and  we  are  therefore  sending  you  (attached  below)  a 
memorandum  of  your  balance,  which  we  would  ask  you  to  kindly  compare 
with  your  books,  advising  us  as  to  its  correctness  or  otherwise. 

If  the  balance  does  not  agree,  please  inform  us  fully  as  to  the  reason 
and  amount  of  the  differences. 

A  stamped  envelope  is  inclosed  for  use  in  replying. 
Very  truly  yours. 


No. 


Certified  Public  Accountants. 

Perforations  here 

19   


The  balance  of  $ under  date  of 

charged  against  my  account  on  the  books  of is  correct. 

Very  truly  yours. 

The  above  form,  or  some  variation  of  it,  was  used  extensively 
for  several  years,  but  it  was  found  to  be  expensive  and  not  en- 
tirely satisfactory.  In  fact,  if  balances  are  correct  there  is  no 
necessity  for  an  acknowledgment. 

The  most  popular  form  at  present  is  as  follows : 


PLEASE  EXAMINE 

this  Statement  carefully.    If  it  is  not  correct,  please 

communicate  DIRECT  with  our  Auditors, 

LYBRAND,  ROSS  BROS.  &  MONTGOMERY 

55  LIBERTY  ST.,  NEW  YORK, 

giving  full  details  of  any  differences. 


This  rubber  stamp  is  used  on  the  regular  statement  forms  of  the 
concern  under  audit  and  is  more  effective  than  any  other  method. 

It  is  advisable  for  the  auditor  to  furnish  to  the  client  en- 
velopes having  on  them  the  auditor's  return  address;  otherwise 
statements  of  accounts  apparently  genuine,  but  actually  fic- 
titious, may  be  returned  to  the  cHent's  office  undelivered  by  the 
post-office,  and  thus  reach  the  clerk  responsible  for  the  fictitious 
accounts.  If  this  happens,  the  clerk  will,  of  course,  destroy  the 
envelope  and  statement. 


THE  DETAILED  AUDIT  527 

Preparation  of  Customers'  Statements. — The  state- 
ments are  prepared  in  the  client's  office  in  the  usual  manner — 
not  by  the  auditor.  The  latter,  however,  should  compare  bal- 
ances with  ledger  accounts  before  mailing  and  the  mailing  should 
be  done  by  the  auditor.  For  some  accounts  no  statements  are 
sent.  A  list  of  these  should  be  prepared  and  approved  by  the 
proper  authority.  Some  auditors  object  to  this  procedure  on 
the  ground  that  customers  who  are  in  the  habit  of  visiting  the 
client's  place  of  business  are  apt  to  disregard  the  request  to  take 
up  differences  directly  with  the  auditor  but  will  in  most  cases 
report  any  discrepancies  directly  to  the  bookkeeper.  Even  if 
custom^ers  are  not  in  the  habit  of  calling  at  the  client's  office, 
they  insist  on  writing  directly  to  his  office  concerning  their  ac- 
counts, because  they  do  not  appreciate  the  value  of  an  independ- 
dent  check.  The  auditor,  therefore,  cannot  depend  on  having 
reported  to  him  all  discrepancies  in  customers'  accounts  through 
the  plan  suggested  above.  As  a  practical  matter,  however,  the 
scheme  will  bring  to  light  any  systematic  fraud,  because  all  cus- 
tomers do  not  object  to  communicating  direct  with  an  auditor. 
If  a  bookkeeper  has  been  systematically  manipulating  customers' 
accounts,  one  or  more  customers  will  so  advise  the  auditor.  He 
is  then  put  on  notice  and  other  instances  of  fraud  should  be  looked 
for. 

Value  of  This  Check. — This  independent  check  is  of  value 
not  only  in  the  disclosure  of  fraud,  but  also  because  of  the  in- 
formation which  it  gives  as  to  the  condition  of  the  accounts  with 
respect  to  unadjusted  items,  allowances,  etc.  It  is  needless  to 
say  that  some  bookkeepers  are  careless  and  others  lazy.  When 
this  is  so,  it  is  important  for  the  auditor  to  find  it  out.  In  all 
classes  of  business  various  claims  and  errors  crop  out  from  time 
to  time.  When  these  affect  customers'  accounts,  adjusting  en- 
tries should  be  made  at  once,  otherwise  the  outstanding  balances 
do  not  reflect  the  true  state  of  the  accounts.  If  a  bookkeeper  is 
lazy  or  careless,  it  will  soon  develop  in  the  replies  from  customers 


528  AUDITING— GENERAL  PRINCIPLES 

to  the  requests  for  confirmations.  In  several  instances  this  in- 
quiry has  demonstrated  a  very  unsatisfactory  condition  the 
cause  of  which  was  not  fraud  but  carelessness.  In  many  in- 
stances, however,  carelessness  leads  to  fraud. 

Whenever  the  auditor  can  check  loose  methods,  he  may 
really  be  preventing  fraud.  The  auditor  who  prevents  fraud  is  a 
very  useful  person. 

It  is  impossible,  in  limited  space,  to  suggest  more  than  an 
outline  of  the  procedure  to  be  followed,  to  ascertain  that  all  in- 
come is  accoimted  for.  The  very  nature  of  a  business  suggests 
to  an  intelHgent  auditor  practically  every  source  of  revenue, 
special  and  ordinary. 

INCOME  FROM   INVESTMENTS 

As  mentioned  elsewhere,  mercantile  and  manufacturing 
firms  and  corporations  frequently  invest  part  of  their  surplus  in 
income-bearing  securities.  Since  these  investments  are  unusual 
transactions,  the  income  from  them  is  not  usually  subjected  to 
internal  audit. 

The  auditor  should  obtain  a  schedule  of  all  securities  held 
during  the  period  of  the  audit  and  should  ascertain  that  all 
dividends  or  interest  accruing  on  them  are  properly  accounted 
for.  If  any  of  the  investments  are  in  inactive  stocks  and  if 
the  dividends  thereon  are  irregular  and  cannot  be  verified 
through  the  usual  channels,  a  schedule  of  collections  should 
be  compiled  and  submitted  for  approval  to  someone  in  au- 
thority. 

If  the  investments  are  all  grouped  in  one  account,  attention 
should  be  called  to  the  desirability  of  opening  a  separate  account 
with  each  one,  and  of  noting  at  the  top  of  the  page  full  particulars 
as  to  the  serial  numbers  of  the  bonds  or  stock  certificates,  to- 
gether with  interest  or  dividend  dates  and  similar  information. 
If  numerous,  it  is  best  to  have  a  subsidiary  ledger  or  record  for 
these  details. 


THE  DETAILED  AUDIT  52^ 

Interest  Receivable 

Under  " Interest  and  Collection  Charges"  (page  563)  and  in 
Chapter  XXIX,  it  is  shown  that  considerable  carelessness  exists 
with  respect  to  the  collection  and  pa)mient  of  interest,  and  at- 
tention is  also  called  to  the  danger  of  accepting  bankers'  figures 
as  infallible. 

Interest  on  mortgage  investments  should  be  verified,  as  shown 
under  ^'Income  from  Investments"  (page  528). 

The  auditor  should  analyze  the  account  for  interest  received 
and  should  separate  that  part  which  is  exempt  from  federal  or 
other  taxation  from  other  interest,  even  if  he  is  not  preparing  the 
income  tax  return. 

Interest  on  loans  where  the  interest  rate  and  other  conditions 
are  not  always  fixed  in  advance  demands  especial  attention.  Few 
businesses  exist,  particularly  among  those  conducted  by  firms 
and  individuals,  where  private  loans  or  advances  do  not  appear. 
These  may  be  to  friends,  or  to  business  associates,  or  to  employees, 
or  to  customers  who  request  temporary  accommodations.  More 
frequently  they  represent  investments  entirely  outside  the  busi- 
ness and  in  connection  with  enterprises  about  which  little  is  known. 

Any  auditor  who  has  had  long  experience  can  recall  in- 
numerable instances  where  men  have  made  fortunes  in  their  own 
business  and  have  squandered  their  entire  surplus,  and  often- 
time  most  of  their  capital,  in  mines,  plantations,  patents,  and  all 
sorts  of  industrial  flotations  about  which  they  had  no  technical 
knowledge  whatever. 

Frequently  these  outside  ventures  commence  in  the  form  of 
small  loans.  Here  the  auditor  can  sometimes  be  of  real  service 
to  his  client.  The  client  should  be  impressed  with  the  neces- 
sity of  keeping  his  own  capital  intact,  and  of  not  making  so-called 
investments  in  the  form  of  loans  to  others  while  borrowing  him- 
self. The  auditor  should  point  out  to  the  client  that  he  is  not  a 
banker,  that  if  loans  or  advances  are  made  to  others,  interest 
thereon  at  current  rates  should  be  paid  promptly,  and  that  the 
loans  should  be  cleaned  up  or  materially  reduced  periodically — 

VOL.  I — 34 


530  AUDITING— GENERAL  PRINCIPLES 

just  as  is  required  by  a  banker.  Considerable  space  is  devoted 
to  this  matter  here  because  borrowers  of  this  class  do  not,  as  a 
rule,  pay  interest  promptly,  and  the  failure  to  make  such  col- 
lections will  give  an  auditor  a  good  opportunity  to  criticize 
unbusinesslike  practices. 

Interest  on  bank  deposits  is  not  often  investigated,  yet  it 
may  be  that  a  rate  of  only  2  per  cent  is  received  when  2  1/2  or  3 
per  cent  may  have  been  arranged.  Therefore  the  auditor 
should  always  verify  the  rate  actually  in  force.  A  rough  esti- 
mate can  usually  be  made  of  the  amount  credited  on  balances. 
Cheques  issued  follow  a  well-defined  course,  except  in  special 
cases,  so  that  the  test  of  a  month  or  two,  based  on  average 
daily  balances  will  disclose  whether  or  not  the  amount  received 
is  approximately  correct.  Frequently  the  auditor  can  have 
these  figures  compiled  by  one  of  the  office  staff  and  thus  reduce 
to  a  minimum  the  time  he  himself  must  spend  thereon. 

Rents  Receivable 

If  the  item  of  income  from  rentals  is  inconsiderable,  the 
records  relating  to  it  are  not  apt  to  be  in  good  condition  for 
auditing. 

List  of  Property. — In  the  first  place  a  complete  list  of  all 
rentable  property  is  essential.  Next  in  importance  is  a  schedule 
of  rentals  which  should  be  received  therefrom.  With  these  two 
points  covered,  the  auditor  can  make  a  satisfactory  audit.  The 
premises  should  be  inspected  and  note  made  of  vacancies,  if  any. 
Vacancies  during  the  period  should  be  listed  and  verification  of 
them  secured  from  some  source  independent  of  the  clerk  in 
charge  of  the  collections. 

The  author  had  nearly  completed  the  audit  of  a  small  rail- 
road company  when  this  question  arose.  The  balance  sheet  dis- 
closed the  ownership  of  some  rentable  buildings.  When  asked 
for  the  records  relating  thereto,  the  treasurer  attempted  to  defer 
the  inquiry,  but  after  a  list  was  secured  and  the  possible  income 


THE  DETAILED  AUDIT  531 

calculated,  he  confessed  that  he  had  misappropriated  most  of 
the  rent  collections.  The  amount  was  comparatively  small — a 
few  hundred  dollars  out  of  total  income  of  several  millions — but 
the  ordinary  income  was  controlled  and  checked  by  other  de- 
partments, so  he  seized  the  only  opportunity  for  fraud  which 
seemed  safe. 

When  Agents  Are  Employed.— Where  collections  are  in  the 
hands  of  reputable  agents,  who  render  periodical  statements,  it  is 
not  necessary  to  check  the  income  in  so  much  detail;  but  careful 
inquiry  should  be  made  to  satisfy  the  auditor  that  the  agent  has 
charge  of  all  the  property,  and  that  the  statements,  when  re- 
ceived, are  checked  both  as  to  collections  and  deductions.  It  is 
obvious  that  the  auditor  will  trace  into  the  cash  receipts  the  total 
amount  turned  over  by  the  agent  for  the  entire  period,  and,  if 
there  is  the  slightest  doubt  as  to  the  genuineness  of  the  state- 
ments submitted,  the  auditor  should  request  the  agent  to  hand 
him  a  memorandum  of  payments  for  the  period. 

Income  from  Securities  Bearing  Low  Rate  of  Interest. 
— As  compared  with  twenty  years  ago,  the  going  rate  of  interest 
has  about  doubled.  At  that  time  good  3  1/2  per  cent  bonds 
freely  sold  at  par.  Today  low  rate  bonds  sell  at  a  considerable 
discount.  The  question  arises  as  to  the  proper  treatment  of  the 
discount.  When  bonds  and  similar  obligations  are  purchased  at 
a  considerable  discount,  the  first  inquiry  of  the  auditor  should 
be  as  to  the  rate  of  interest.  When  the  stated  rate  is  under  the 
market  or  effective  rate,  it  can  properly  be  assumed  that  such 
part  of  the  discount  as  can  be  ascribed  thereto  should  be  amor- " 
tized  and  periodically  credited  to  income.  When  the  discount 
can  be  ascribed  to  apprehension  as  to  the  safety  of  the  principal 
the  security  should  be  dealt  with  as  a  speculative  investment 
and  no  credit  be  made  to  income  unless  or  until  the  situation 
changes.  If  the  apprehension  proves  not  to  be  well  founded,  the 
discount  should  be  amortized;  if  the  situation  changes  for  the 
worse,  the  book  value  should  be  written  down. 


532  AUDITING— GENERAL  PRINCIPLES 

From  an  accounting  point  of  view,  the  accrual  system  de- 
mands that  each  fiscal  period  shall  contain  the  charges  and 
credits  which  belong  to  it.  Expediency  will  sanction  the  post- 
ponement of  profit- taking  until  realization  takes  place;  but 
expediency  may  result  in  inaccurate  balance  sheets  and  income 
accounts. 

MISCELLANEOUS  INCOME 

It  is  not  practicable  nor  necessary  to  discuss  in  detail  all 
classes  of  income  which  arise  in  various  lines  of  business.  The 
following  classes  are  illustrative  of  the  procedure  to  be  followed 
in  the  case  of  any  special  class  of  income.  In  addition  there 
are  possible  items  of  income  which  are  general  in  their  nature. 

Discount  for  Prepayment 

There  is  some  difference  between  interest  received  from 
customers  on  notes  receivable  and  cash  discounts  allowed  by 
creditors  for  prompt  or  anticipated  cash  payments,  although 
theoretically  they  both  represent  a  profit  or  return  upon  the 
capital  invested  in  the  business.  Interest  received  on  notes  is 
almost  invariably  calculated  at  the  legal  rate  of  interest  and  is, 
in  effect,  an  offset  to  the  interest  paid  upon  money  borrowed. 
This  becomes  apparent  if  we  consider  the  possibility  of  dis- 
counting the  notes  receivable,  for  in  that  case  the  interest  on 
the  notes  is  added  to  the  face  of  the  notes  and  the  bank  discount 
is  deducted  therefrom.  It  is  not  customary  or  necessary  to 
credit  the  interest  to  one  accoimt  and  to  charge  the  discount  to 
another  account. 

The  rate  of  interest  allowed  for  prepayments,  however,  is 
purely  arbitrary  and  fluctuates  to  a  considerable  extent.  Most 
concerns  wish  to  know  the  amount  realized  from  this  source.  A 
separate  ledger  account  should  be  kept  for  it. 

As  an  indication  of  some  of  the  rates  of  cash  discount  which 
are  allowed,  the  following  were  given  in  replies  made  by  manu- 


THE  DETAILED  AUDIT 


533 


facturers  in  May,  192 1,  to  a  query  of  the  Merchants'  Association 
of  New  York : 


Baby  Vehicles: 

2%— 30  days 

60  days  net 

Biscuits  and  Crackers: 

1% — 10  days 

Chairs: 

2%— 30  days  (or  less) 

Chemicals: 

No  uniform  practice 

Chewing  gum: 

>^%— 3odays 

Confectionery: 

2% — 10  days 

30  days  net 

Cooperage: 

30  days  net 

Feed: 

No  discounts  allowed 

Flint  and  Lime  Glass: 

i%— 15  days 

30  days  net  (from 
date  of  invoice) 

Gears: 

1% — 10  days 

30  days  net 

Automotive  branch 

2% — 10  days 

30  days  net 

Large  gear  or  mill  work : 

usually  30  days  net 

Glue  and  Gelatine: 

2% — 10  days 

30  days  net 

(Some  few 

r  i%— 10  days) 

Hardware:  (small) 

2% — 10  days 

60  days  net 

Horn  and  Celluloid: 

2%— 10  days 

30-60  days  net 

(Sometimes  30 

days 

extra) 

Malleable  Castings: 

No  discounts  allowed 

Medicinal     chemicals     and 

essential   oils    (deal   only 

with  wholesalers) : 

1% — 10  days 

30  days  net 

Paints  and  Oils: 

i%— 10  days 

30  days  net  (or  less) 

Pharmaceuticals: 

2% — 10  days 

60  davs  net 

Stamps: 

i%— 10  days 

30  days  net 

Some  mfrs. 

2% — 10  days 

Many  of  largest  mfrs. 

10   days  net 

Stoves: 

2% — 10  days 

30  days  net  (or  60 
days  with  trade 
acceptance) 

Surgical  dressings: 

1% — 10  days 

30  days  net 

Varnishes: 

2% — 10  days 

60  days  net  (or  less) 

Trade  Discounts. — Trade  discounts  should  be  deducted 
directly  from  purchases  on  the  one  hand  and  from  sales  on  the 
other.  That  is,  no  ledger  account  should  be  kept  for  trade  dis- 
counts.    The  term  itself  rarely  appears  in  books  of  account. 


534  AUDITING— GENERAL  PRINCIPLES 

The  test  of  a  trade  discount  is  the  rate.  In  some  lines  of 
business  a  discount  of  7  per  cent  is  allowed  for  payment  within 
thirty  days.  This  is  not  a  cash  discount,  for  no  business  house 
would  pay  that  rate  for  money.  Therefore  the  concern  which 
receives  the  discount  cannot  credit  it  to  interest.  Frequently, 
moreover,  notes  are  given;  the  7  per  cent  is  deducted  from  the 
face  of  the  bill  and  interest  at  the  rate  of  6  per  cent  per  annum  is 
added  to  the  balance  for  the  term  of  the  note.  This  clearly  shows 
that  the  deduction  represents  a  trade,  not  a  cash,  discount. 

The  distinction,  therefore,  is  based  on  the  answer  to  the 
query:  Is  the  rate  one  which  is  obviously  granted  for  anticipa- 
tion of  obligations  not  due?  For  instance,  the  strict  enforce- 
ment of  the  discount  terms  ^'2  per  cent  ten  days,  net  thirty 
days  "  indicates  that  the  2  per  cent  is  an  earning  and  not  a  deduc- 
tion from  the  purchase  price.  As  a  general  rule  any  discount 
in  excess  of  the  terms  just  mentioned  may  be  treated  as  a  trade 
discount. 

Realizations  from  Items  Previously  Charged  to  Income 

Among  the  miscellaneous  items  of  income  which  may  be 
found  in  almost  any  business,  and  to  which  the  auditor  should 
pay  particular  attention  (chiefly  because  such  attention  may  not 
be  expected),  are  realizations  from  assets  made  subsequent  to 
the  time  when  such  assets  were  charged  off  to  income  as  uncol- 
lectible. The  procedure  is  not  so  difficult  as  it  appears  at 
first  sight,  because  the  number  of  debits  to  income  over  a 
period  of  years  is  not  usually  very  great.  Moreover,  since  only 
a  small  proportion  of  these  items  can,  in  any  event,  admit  of  a 
subsequent  realization,  it  is  not  much  of  a  task  for  an  auditor 
to  analyze  the  ''possible"  items  and  scrutinize  them  solely  to 
ascertain  probable  or  possible  collections. 

Customers'  accounts  are  the  most  prolific  source  of  delayed 
realization  because  they  are  often  written  off  after  bankruptcy 
proceedings  are  instituted,  and  before  the  final  dividend  is  paid. 

Some  bankruptcies  extend  over  a  long  period  of  years,  so  that 


THE  DETAILED  AUDIT  535 

every  such  account  written  off  should  show  beyond  any  doubt 
that  a  final  dividend  has  been  received.  Where  accounts  have 
been  written  off  without  any  evidence  that  bankruptcy  pro- 
ceedings were  ever  started,  the  written  authority  for  such  action 
should  be  submitted  to  the  auditor. 

Stocks,  bonds,  loans  receivable,  and  similar  items  are  some- 
times written  off  before  the  properties  or  persons  responsible  are 
finally  adjudicated  bankrupt  or  otherwise  definitely  declared  to 
be  hopeless.  This  line  of  inquiry  does  not  require  much  time 
but  experience  has  proved  its  worth. 

Sales  of  Building  Lots 

In  the  audit  of  a  land  or  real  estate  company,  it  should  at  once 
occur  to  the  auditor  that  he  must  look  carefully  for  receipts  from 
sales  of  building  lots.  Now  the  last  places  to  examine  are  the 
receipt  side  of  the  cash  book  and  the  sales  book  or  other  record  of 
the  sales.  Yet  when  he  asks  for  a  record  of  sales,  it  is  these  to 
which  he  is  directed.  At  least  nine  out  of  ten  times  the  client  ex- 
pects him  to  take  these  records  as  starting  points  rather  than  to 
consider  such  a  record  as  a  goal  toward  which  he  is  working. 

There  probably  never  has  been  a  land  company  which  did 
not  issue  a  map  of  its  property  nicely  marked  off  into  lots  with  a 
number  and  block  for  every  lot.  What  is  simpler  than  for  the 
auditor  to  take  a  map  and  one  of  the  printed  price  lists  usually 
available  and  proceed  to  account  for  every  lot?  All  lots  sold  for 
less  than  list  price  should  pass  inspection  by  a  duly  authorized 
officer.  All  lots  not  accounted  for  as  sold  should  be  on  the  ''for 
sale"  list  or  else  specified  as  being  set  apart  for  particular  pur- 
poses. These  purposes  should  be  evidenced  by  resolutions  of 
the  board  of  directors  or  other  authority  properly  expressed. 

Since  most  lots  are  sold  on  the  instalment  plan,  the  auditor 
should  look  for  collections  of  interest  on  the  deferred  instalments 
and  should  require  that  every  such  item  be  accounted  for. 

Thus  through  the  rather  simple  process  of  most  business 
enterprises  it  is  possible  to  think  out  the  sources  of  revenue  in- 


536  AUDITING— GENERAL  PRINCIPLES 

stead  of  using  the  books  as  a  guide.  By  so  doing  the  auditor 
avoids  the  danger  of  being  influenced  by  the  entries  shown 
therein  and  thus  of  losing  sight  of  the  fact  that  those  entries  are 
not  all  which  should  appear. 

Services  and  Other  Charges  Billed  in  Advance 

Verification  of  income  from  subscriptions  or  other  items  repre- 
senting charges  for  services  or  goods  to  be  furnished  or  delivered 
at  regular  intervals,  requires  careful  examination  of  the  amount 
charged  in  order  to  determine  what  part  of  it  has  actually  been 
earned.  For  instance,  suppose  that  a  contract  is  made  on  Janu- 
ary I  to  furnish  a  monthly  service  for,  say,  $600  per  annum, 
which  is  to  be  collected  in  one  amount.  Let  us  assume  that  on 
March  i  the  amount  is  still  uncollected.  There  is  then  an 
account  receivable  of  $600  against  which  there  should  be  set  up 
a  reserve  of  $500  for  that  part  of  the  contract  which  is  unearned 
on  March  i .  In  this  case  the  situation  does  not  possibly  warrant 
stating  the  transaction  net,  as  an  account  receivable  of  $100. 

Income  from  Corporation's  Own  Issues 

Oftentimes  the  securities  of  a  corporation,  such  as  bonds  and 
notes,  are  purchased  for  the  account  of  the  issuing  corporation  by 
trustees,  to  whom  the  corporation  transfers  funds  under  sinking 
fund  or  other  trust  agreements.  For  purposes  of  accounting 
between  the  corporation  and  its  creditors  it  is  necessary  to  treat 
such  a  transaction,  including  the  income  from  the  securities 
purchased,  as  if  the  corporation  were  dealing  with  securities  not 
issued  by  itself.  The  procedure  must,  of  course,  be  governed 
by  the  terms  of  the  agreement.  Usually  the  income  is  added  to 
the  funds  in  the  hands  of  the  trustees  and  does  not  return  to  the 
corporation's  own  treasury.  The  benefit  to  the  corporation  lies 
in  the  discharge  of  its  obligations. 

Aside  from  the  contractual  obhgations  existing  between  cor- 
poration and  trustee,  such  transactions  require  attention  from 
the  point  of  view  of  good  accounting  practice.    A  corporation 


THE  DETAILED  AUDIT  537 

cannot  receive  income  from  itself;  therefore,  interest  on  its  bonds 
which  is  paid  to  trustees  who  hold  the  title  to  the  bonds  for  the 
sole  account  of  the  corporation  which  issues  them,  is  a  payment 
and  receipt  of  interest  only  in  so  far  as  the  trustees  are  concerned. 
This  point  is  of  importance  in  tax  and  other  questions.  There 
should  be  no  great  difficulty  in  settling  any  specific  question  so 
long  as  no  attempt  is  made  to  treat  corporation  and  trustees  as 
separate  entities,  except  in  so  far  as  the  agreement  between 
them  is  concerned. 


CHAPTER  XXV 
THE  DETAILED  AUDIT— PURCHASES  AND  EXPENSES 

Auditors  have  given  altogether  too  much  attention  to  the 
forms  and  evidences  of  payments  and  too  little  attention  to  the 
purposes  of  the  payments  and  the  content  of  vouchers.  The 
United  States  Treasury  spends  hundreds  of  thousands  of  dollars 
annually  and  compels  other  departments  of  the  government  to 
spend  even  greater  sums  in  securing  peculiar  (almost  weird) 
forms  of  vouchers.  Disallowances  due  to  informalities  are  made 
aggregating  hundreds  of  millions  of  dollars,  taking  up  the  time 
of  competent  clerks  who  should  be  empowered  to  ignore  the 
form  and  investigate  the  substance  of  the  expenditures.  In 
many,  perhaps  most,  cases  of  fraud  routine  methods  are  followed 
and  standard  forms  are  used;  the  dishonest  person  is  more  con- 
cerned with  formality  than  is  the  honest  person.  It  is  not 
hkely  that  many  persons  will  attempt  to  defraud  the  govern- 
ment or  anyone  else  by  the  use  of  obviously  insufficient  vouchers. 

Therefore,  the  best  advice  regarding  the  verification  of 
expenditures  is  to  subordinate  form  and  devote  special  attention 
to  the  purpose  and  the  necessity  of  all  payments. 

VOUCHERS 

It  must  be  admitted  that  the  examination  of  vouchers  is 
necessary  and  valuable,  but  with  respect  to  relative  importance, 
such  work  should  be  placed  toward  the  end  of  the  list.  If  a 
careful  comparison  of  vouchers  with  cash  books  would  dis- 
close improper  or  extravagant  purchases  or  expenses,  the  very 
considerable  work  involved  would  be  justified ;  but  unfortunately 
the  ordinary  voucher,  so-called,  is  usually  little  more  than  a 
receipt  for  a  given  sum  of  money  and  is  usually  of  so  little  prac- 

538 


THE  DETAILED  AUDIT  539 

tical  use  that  many  concerns  never  insist  on  vouchers  nor  do  they 
preserve  them  when  they  are  furnished. 

Procedure 

Of  course,  this  is  a  matter  which  should  not  be  discussed 
with  anyone  whose  accounts  are  being  audited.  WTiere  vouchers 
are  taken,  an  auditor  should  call  for  vouchers  covering  all  pay- 
ments and  require  that  they  be  arranged  in  order  to  correspond 
with  the  cash  book  entries.  He  should  not  allow  it  to  be  known 
that  there  is  any  probability  of  his  not  checking  any  part  of  the 
vouchers,  or  else  it  will  be  difficult  to  secure  them  properly  and 
have  them  arranged  in  order.  If  a  cheque  bears  on  its  face  or 
back  any  indication  of  its  purpose,  it  is  the  best  receipt  for 
money  paid  that  can  be  secured.  If  it  bears  no  evidence  of  its 
purpose,  but  can  be  readily  identified  with  a  particular  bill  or 
invoice,  it  still  is  a  better  voucher  than  a  receipted  bill.  The 
comparison  of  vouchers  with  a  cash  book  without  the  identifica- 
tion of  the  entries  in  the  cash  book  with  the  cheques  is  worse  than 
negligence ;  since  the  sole  purpose  of  vouching  cash  is  to  ascertain, 
as  nearly  as  possible,  that  the  pa)anents  represent  an  equivalent 
in  value  to  the  payers  and  that  the  equivalent — that  is,  the  dis- 
charge of  a  like  liability — is  received  when  the  cash  is  paid.  A 
mere  receipt  for  so  much  money,  which  can  readily  be  forged,  is 
poor  evidence  of  a  legitimate  payment;  but  a  paid  cheque,  properly 
indorsed  and  otherwise  identified  as  representing  the  payment  of 
a  definite  liability,  is  pretty  fair  proof  that  the  money  has  reached 
a  creditor.  If  the  auditor  follows  it  up  by  a  careful  scrutiny  of 
the  documents  supporting  the  cheque,  he  is  on  the  right  track. 

Paid  Cheques  as  Evidence 

It  must  be  remembered,  however,  that  a  paid  cheque  unsup- 
ported by  other  documents  is  not  conclusive  evidence  of  the 
propriety  of  a  payment.  This  is  well  illustrated  by  the  following 
instance  in  the  author's  experience : 

The  accounts  of  a  district  school  board  which  had  passed  out 


540  AUDITING— GENERAL  PRINCIPLES 

of  existence  were  to  be  audited.  Only  a  small  amount  of  funds 
was  handled,  the  total  collection  of  taxes  for  district  school  pur- 
poses being  about  $i  5,000  per  annum.  The  records  submitted  to 
the  auditors  were  fairly  complete,  with  the  exception  that  no  paid 
bills  were  turned  over  to  the  new  board.  The  paid  cheques, 
however,  were  intact,  the  cash  book  had  been  well  kept,  with 
some  attempts  at  classification  of  expenditures,  and  the  minute 
book  contained  complete  lists  of  all  the  bills  approved  for  pay- 
ment by  the  board  at  its  meeting. 

Every  disbursement  recorded  in  the  cash  book  was  foimd  to 
be  supported  by  a  paid  cheque,  and  all  the  payments  had  been 
duly  authorized  by  the  board.  Most  of  the  payments  were  of 
very  moderate  amounts.  Thus  far  everything  appeared  to  be  in 
order.  Practically  nothing  had  been  seen  to  arouse  the  auditor's 
suspicions.  Several  pa)mients,  each  for  a  little  less  than  $150, 
had,  however,  been  made  to  a  wholesale  drug  house  and  to  a 
pharmacist,  respectively.  The  auditors  could  not  think  what 
articles  aside  from  sponges  would  be  purchased  from  these 
sources,  and  decided  to  obtain  duplicate  bills  in  order  to  ascer- 
tain the  nature  of  the  articles  purchased.  The  request  for  such 
bills  was  in  both  cases  met  with  the  reply  that  no  payment  of  the 
amount  mentioned  had  been  received  from  the  school  board. 
Further  investigation  developed  the  fact  that  the  indorsements 
on  the  cheques  had  been  forged,  which  fact  the  auditor  could  not 
have  determined  from  an  examination  of  the  cheques  themselves 
since  they  bore  evidence  of  having  passed  through  bank  in  the 
usual  way.  It  finally  developed  that  the  indorsements  had  been 
forged  by  a  member  of  the  school  board. 

Certified  Bills  as  Evidence. — Furthermore,  even  a  bill 
certified  as  to  receipt  of  the  articles  shown  thereon,  approved  for 
payment  by  the  authorized  officials,  and  evidenced  as  to  actual 
payment  by  an  indorsed  cheque  which  has  passed  through  bank 
in  the  regular  manner,  may  not  be  conclusive  evidence  of  the 
honesty  of  a  transaction.     Another  school  board  (not  the  one 


THE  DETAILED  AUDIT  541 

mentioned  in  the  preceding  paragraphs)  had  purchased  a  piano 
for  $450.  The  documents  supporting  the  payment  were  all  in 
regular  order,  and  the  piano  itself  was  in  existence  as  proof  of 
the  fact  that  the  article  charged  for  on  the  bill  had  actually  been 
received.  The  auditors,  however,  made  a  personal  visit  to  the 
store  where  the  piano  had  been  purchased  and  without  revealing 
their  identity  made  inquiries  as  to  the  prices  of  various  styles  of 
pianos.  They  were  offered  exactly  the  same  style  of  piano  for 
which  the  school  board  had  paid  $450  for  $275,  and  this  without 
any  ''haggling"  over  the  price.  The  piano  concern  later  ad- 
mitted that  when  it  received  the  school  board's  cheque  for  $450, 
it  (the  piano  concern)  paid  $200  in  currency  to  the  bearer  of  the 
cheque.  Of  course,  the  ''refund"  never  foimd  its  way  back  into 
the  school  board  treasury. 

When  Paid  Cheques  Are  Sufficient. — In  small  concerns 
many  items  of  payment  are  posted  direct  to  expense  and  other 
general  ledger  accounts.  The  vouchers  for  such  items  should 
include  complete  evidence  of  their  genuineness.  The  best 
vouchers  for  payments  posted  direct  to  personal  accounts  are  the 
paid  indorsed  cheques,  because  the  credit  side  of  the  personal 
ledger  accounts  will  have  been  compared  with  the  original  in- 
voices; consequently,  very  little  evidence  of  the  discharge  of  the 
obligation  is  required. 

An  auditor  can  greatly  assist  his  client  by  looking  into  the 
various  operations  surrounding  a  payment  as  well  as  by  passing 
on  the  question  of  whether  or  not  it  is  a  bona  fide  transaction. 

Purchase  Invoices 

The  bill  or  invoice  should  bear  on  its  face  all  marks  or  initials 
needed  to  indicate  that  the  goods  or  materials  were  received  in 
proper  quality  and  quantity;  that  they  were  as  ordered,  which 
includes  an  approval  of  the  price,  provided  it  was  recorded  at  the 
time  the  order  was  given,  or  an  approval  by  a  responsible  and 
authorized  official  if  the  price  was  not  fixed  in  advance;  that  if 


542  AUDITING— GENERAL  PRINCIPLES 

the  quotation  was  ''delivery  free,"  freight  was  not  paid,  or,  if 
paid,  has  been  charged  back  to  the  vendor;  that  where  custom 
permits  or  any  other  indication  appears  of  a  cash  discount  being 
in  order,  it  was  deducted;  that  in  all  other  respects  the  purchase 
was  in  order,  including  the  checking  of  the  calculations,  the 
notations  as  to  the  department  or  account  to  be  charged,  etc. 

Test  of  Purchasing  Department. — Many  large  estabhsh- 
ments  have  purchasing  departments  which  assemble  more  or 
less  complete  data  comprising  quotations  on  practically  all  the 
commodities  purchased.  In  such  cases  the  auditor  should  make 
a  test  of  such  records  to  determine  whether  the  purchasing 
department  appears  to  be  buying  at  the  lowest  possible  prices. 

Internal  Check 

Inquiry  should  be  made  as  to  whether  the  receiving  clerks 
keep  an  independent  record  of  all  goods  received  irrespective  of 
invoices  to  cover,  and  whether  the  subsequent  comparison  of 
these  records  is  carried  out  intelligently  and  completely. 

As  stated  above,  these  invoices  should  be  throughly  tested  to 
ascertain  the  internal  method  of  checking  their  accuracy;  but 
the  auditor  should  never,  as  a  matter  of  course,  attempt  to  verify 
the  whole  of  the  purchase  vouchers  unless  he  has  a  further  pur- 
pose in  view  than  to  ''audit  the  books."  In  a  large  concern  the 
auditor  does  not  think  of  examining  every  purchase  invoice.  He 
makes  copious  tests  and,  if  nothing  suspicious  is  discovered,  is 
willing  to  certify  that  the  accounts  are  correct.  An  auditor 
should  not  inspect  every  voucher,  even  in  a  small  estabUshment, 
unless  there  is  some  special  reason  for  doing  so. 

What  Vouchers  to  Examine 

There  are  many  more  important  things  to  do  in  an  audit,  and 
the  time  spent  on  vouchers  must  bear  a  proper  relation  to  the 
time  used  for  other  purposes  and  to  the  fee,  if  the  latter  is  to  be 
fair  to  both  auditor  and  cHent.    Some  books  and  articles  on  an- 


THE  DETAILED  AUDIT  543 

diting  recommend  the  examination  of  all  vouchers.  These  books, 
however,  are  not  based  on  successful  experience  or  upon  a  proper 
realization  of  the  service  which  the  client  is  entitled  to  receive. 

If  a  system  of  internal  check  is  in  force,  it  is  not  necessary  to 
inspect  every  invoice ;  a  complete  test  should  be  made  to  see  that 
there  is  a  strict  compliance  with  the  rule  heretofore  mentioned, 
but  this  test  is  completed  by  selecting,  say,  three  or  four  months 
out  of  twelve  and  examining  each  item,  always  including  the  last 
month  of  the  period.  The  auditor  should  then  look  over  the 
cash  book  very  carefully  for  the  other  eight  or  nine  months,  and 
in  connection  with  his  analysis  of  the  ledger  accounts  he  can  note 
any  unusual  or  suspicious-looking  item  and  call  for  the  voucher 
covering  it.  This  obviates  the  necessity  of  checking  over  the 
mass  of  documents  which,  he  has  satisfied  himself  by  his  general 
test,  represent  purchases  for  the  proper  and  ordinary  purposes  of 
his  client.  The  scrutiny  of  the  ledger  accounts,  or  analysis  if 
necessary,  is  important  if  charges  have  been  made  to  plant 
accounts.     These  must  always  be  supported  by  proper  vouchers. 

Illustrations. — In  a  bankruptcy  case  it  was  found  that  the 
proprietors  had  personally  withdrawn  large  sums  and  had  made 
it  appear  on  the  books  that  equivalent  amounts  were  expended 
for  merchandise.  Cheques  and  cash  received  from  customers 
were  entered  in  the  cash  book  and  from  them  credits  were  posted 
to  customers'  accounts.  The  remittances  themselves  were  de- 
posited, not  in  the  company's  regular  bank  account,  but  in  a 
secret  bank  in  another  state.  This  latter  bank  account  was 
used  for  the  personal  benefit  of  the  proprietors.  To  keep  the 
company's  bank  account  in  balance,  regular  cheques  were  drawn 
to  the  order  of  fictitious  creditors,  to  agree  with  the  entries  in 
the  cash  book  for  the  customers'  cheques.  These  were  indorsed, 
taken  to  the  bank  and  deposited  in  the  regular  account.  The 
creditors'  accounts  were  debited  with  the  cash  purported  to  be 
paid  to  them,  and  credited  with  the  fictitious  purchase  items. 

In  a  defalcation  amounting  to  over  $20,000,  the  cashier,  in 


544  AUDITING— GENERAL  PRINCIPLES 

order  to  conceal  the  embezzlement  of  cash  sales,  drew  cheques  to 
legitimate  creditors  for  amounts  due,  and  entered  the  payments 
in  the  cash  book  $i,ooo  in  excess  of  the  correct  amounts.  The 
fraud  would  have  been  discovered  by  comparing  the  cheque 
stubs  with  the  cash  book,  or  by  vouching  all  payments.  Usually, 
however,  the  cashier  selected  but  one  or  two  months  in  each 
year  for  the  fraudulent  entries,  so  that  an  auditor  who  selected  a 
few  months'  work  out  of  the  twelve  for  a  test,  might  overlook  the 
dishonest  entries.     The  cashier's  procedure  was  as  follows: 

The  bank  account  was  first  reconciled  with  the  correct 
amounts  appearing  on  the  stubs,  after  which  the  stubs  were 
raised  to  agree  with  the  larger  amounts  in  the  cash  book.  The 
fiscal  year  of  the  concern  ended  February  28.  The  sum  of 
$22,800  was  covered  up  as  follows: 

Cheques  to  creditors  were  entered  in  the  cash  book,  each 
$1,000  greater  than  the  correct  amount: 

1 9 10,  May,  one  item 

191 1,  Jan.,  one  item 
191 1,  Oct.,  two  items 
1914,  Jan.,  five  items 
1 9 14,  Dec,  five  items 

The  cash  book  balance  was  carried  forward  to  the  beginning 
of  the  next  month  insufficient  by  $3 ,000.  Since  this  would  throw 
the  books  out  of  balance,  the  debit  footing  of  the  merchandise 
account  in  the  general  ledger  was  increased  $3,000.  The  foot- 
ing of  the  "merchandise  purchased"  column  on  the  payment 
side  of  cash  book  was  raised  $2,000.  The  cash  book  balance  was 
reduced  $3,800,  and  the  debit  item  of  merchandise  purchased,  in 
the  journal,  was  increased  $3,800.  The  credit  posting  to  the 
creditors'  accounts  was  for  the  correct  amount,  i.e.,  $3,800  less 
than  the  entry  first  called  for. 

When  Extra  Precaution  Is  Required.— In  making  the 
test,  care  must  be  taken  to  ascertain  that  bills  are  made  out  to 


THE  DETAILED  AUDIT  545 

the  concern  under  audit  and  not  to  its  officers  or  clerks.  Of 
course,  if  the  disposition  of  the  things  purchased  is  checked,  such 
an  irregularity  is  disclosed. 

The  names  of  the  payees  may  be  those  with  whom  the  clerks, 
as  well  as  the  concern  itself,  may  possibly  be  dealing.  In  such 
cases  some  extra  precaution  should  be  used  in  examining  the 
original  invoices.  For  instance,  a  cheque  drawn  to  the  order  of 
and  indorsed  by  a  department  store  or  a  tax  collector  is  not  suf- 
ficient evidence  as  to  the  propriety  of  the  payment.  If  original 
invoices  of  this  nature  are  said  to  be  missing,  duplicates  should  be 
requested  and  the  auditor  should  not  be  put  off  with  any  excuse. 

It  is  important  to  know  not  only  that  the  entries  purporting 
to  represent  purchases  made  are  proper,  but  that  all  invoices  for 
purchases  actually  made  have  been  entered  previously  to  closing 
the  books.  This  can  be  quite  satisfactorily  tested  where  there  is 
adequate  system  of  recording  purchase  orders  issued,  of  keeping 
record  of  incoming  goods,  and  of  checking  invoices  against  order 
and  receiving  records.  The  comparison  of  creditors'  state- 
ments with  the  accounts  payable  record  should  under  ordinary 
circumstances  also  enable  the  auditor  to  detect  the  omission  of 
purchase  invoices. 

Irish  Woolen  Mill  Case 

In  the  case  of  Irish  Woolen  Mill  Company ,  Ltd.,  v.  Tyson  and 
others,^  the  auditor  was  held  liable  for  negligence  because  he 
failed  to  detect  the  intentional  omission  of  purchase  invoices 
when  the  books  were  closed  and  the  subsequent  entry  of  the  in- 
voices in  the  following  fiscal  period.  The  purpose  of  the  com- 
pany's secretary  was  to  make  a  better  showing  than  its  operations 
and  financial  condition  justified.  The  court  held  that  the  audi- 
tor, who  had  made  monthly  audits  for  a  number  of  years,  should 
have  had  his  suspicions  aroused  by  the  fact  that  invoices  were 
charged  into  each  period  which,  according  to  their  date,  belonged 


Acct.  L.  R.,  1900,  p.  13  (Irish  Court  of  Appeal,  January  20,  1900). 
VOL.  I — 35 


54^  AUDITING— GENERAL  PRINCIPLES 

in  a  previous  period,  and  that  had  he  then  made  the  investigation 
which  this  suspicious  circumstance  called  for,  the  fraud  would 
have  been  detected. 

Missing  Vouchers 

These  are  a  source  of  much  needless  work  to  many  auditors. 
If  in  an  audit  no  evidence  whatever  of  fraud  is  found,  and  if  the 
payments  for  which  vouchers  are  not  submitted  appear  in  every 
way  to  be  regular,  it  is  usually  a  waste  of  time  to  list  them  in  detail, 
and  consume  a  lot  of  time  locating  them.  In  most  cases  they  will 
not  be  found,  since  many  vouchers  are  never  returned  or  are 
mislaid  or  lost  in  the  mails. 

No  specific  rule  can  be  formulated  for  treating  missing 
vouchers,  but  the  author  wishes  to  go  on  record  as  opposed  to 
the  contention  of  some  auditors  who  regard  this  point  as  a  very 
serious  one  in  every  audit.  The  experience  of  the  author  con- 
firms his  belief  that  where  a  cashier  enters  an  irregular  or  wholly 
fictitious  payment,  he  is  always  sure  to  have  a  voucher  to  cover. 

Vouchers  for  Petty  Cash  Payments,  Pay-RoU,  etc. 

Where  pa5nnents  are  made  for  expenses,  wages,  and  similar 
purposes,  and  where  there  is  no  ledger  account  with  the  payee, 
great  care  must  be  taken  to  ascertain  that  the  amounts  have  not 
been  overstated,  either  by  fraudulently  raising  the  figures  on  the 
bill  or  memorandum  or  by  entering  a  larger  amount  in  the  cash 
book  than  the  voucher  represents. 

Petty  Cash. — Vouchers  are  often  altered  and  petty  cash 
pajnnents  are  frequently  the  subject  of  manipulation.  Junior 
clerks  see  how  easy  it  is  to  hand  in  a  memorandum  calling  for 
$io  postage  when  $5  is  all  that  is  necessary,  or,  in  fact,  used. 
Having  done  this,  they  gradually  extend  their  field  of  operation 
until  large  sums  are  abstracted.  Postage  or  mail  books  are  in 
general  use  in  England,  and  if  more  generally  adopted  here 
would  save  many  a  boy  from  the  penitentiary.     It  is  a  grave 


THE  DETAILED  AUDIT  547 

responsibility  for  any  employer  to  permit,  or  any  auditor  to 
approve,  a  loose  or  inefficient  system  for  handling  petty  cash, 
postage,  etc. 

A  large  percentage  of  young  boys  who  are  employed  in  the 
business  districts  of  our  large  cities  and  who  have  access  to  or  can 
draw  from  petty  cash  funds,  are  constantly  following  the  races 
through  the  worthless  afternoon  papers,  through  poolrooms,  or 
in  other  ways.  Conversations  in  large  offices  often  indicate  the 
keenest  interest  in  the  results  of  the  races  not  only  near  New 
York,  but  throughout  the  country.  Professional  auditors  should 
take  a  firm  stand  on  all  questions,  pubHc  or  private,  which  affect 
gambling. 

Procedure. — Coming  back  to  petty  cash  vouchers,  in  view 
of  the  informahty  of  many  of  them,  the  auditor's  best  protection 
is  to  have  some  responsible  person  scrutinize  the  payments, 
rather  than  the  vouchers  themselves,  and  indicate  his  approval 
by  initialing  each  page  or  each  month  of  the  petty  cash  book. 
The  whole  question  of  petty  cash  vouchers  is  one  which  calls  for 
the  exercise  of  good  judgment  rather  than  the  application  of 
fixed  rules.  The  auditor  should  take  this  view  of  it  rather  than 
feel  that  it  is  merely  a  matter  of  comparing  pieces  of  paper  with 
certain  entries  on  the  payment  side  of  a  cash  book. 

There  is  no  great  objection  to  examining  every  voucher  if 
the  concern  is  not  too  large,  if  the  auditor  has  plenty  of  time,  and 
if  he  does  it  properly;  but  he  should  relegate  the  inspection  of 
vouchers  to  its  proper  place  and,  if  pressed  for  time,  he  should 
attend  first  to  more  important  matters. 

If  a  test  is  considered  sufficient,  the  auditor  may  verify  all  of 
the  vouchers  for  a  certain  period,  or  all  vouchers  exceeding  a 
certain  amount  for  the  entire  period. 

It  is  important  that  the  records  of  the  petty  cashier  be  veri- 
fied periodically  by  an  ''outside"  auditor.  In  a  recent  case  the 
manager  of  a  cafeteria  maintained  by  the  corporation  for  its 
employees,  was  entrusted  with  a  small  fund  for  the  purpose  of 


548  AUDITING— GENERAL  PRINCIPLES 

paying  the  current  expenses  of  the  cafeteria  and  of  cashing  small 
cheques.  He  was  supposed  to  deposit  in  bank  daily  all  receipts 
in  excess  of  the  original  fund  so  that  only  the  amount  originally 
turned  over  to  him  would  remain  in  his  hands.  An  officer  of  the 
corporation  induced  the  manager  to  cash  his  personal  cheques 
from  the  fund  and  to  hold  the  cheques  undeposited.  This  con- 
tinued for  a  period  of  ten  months,  when,  upon  an  investigation 
being  made,  it  was  found  that  the  manager  was  holding  over 
thirty  worthless  cheques,  the  loss  aggregating  an  amount  almost 
three  times  as  much  as  the  manager  should  have  had  in  his  hands 
at  any  one  time. 

Imprest  System  for  Petty  Cash. — There  are  numerous 
ways  of  handling  petty  cash,  but  unfortimately  most  of  them  pro- 
vide little  or  no  check  upon  the  cashier  and  afterward  furnish  no 
evidence  of  the  faithful  discharge  of  his  trust. 

The  method  of  charging  all  petty  expenditures  in  a  Imnp  sum 
to  an  expense  accoimt  known  as  "petty  expenses"  is  a  most 
common  one,  and  one  that  is  highly  undesirable.  Fraud  there- 
under often  occurs.  The  older  method  of  paying  such  expenses 
out  of  incoming  cash  or  out  of  cash  received  from  cash  sales, 
frequently  without  making  any  entry  whatever,  is  still  worse. 

The  most  satisfactory  method  is  that  known  as  the  "imprest " 
system.  The  petty  cashier  is  provided  with  a  fund  of  $ioo  or 
$500,  or  whatever  amount  is  necessary  to  meet  the  average  ex- 
penses of  two  weeks  or  a  month.  This  amount,  when  paid  to 
him,  is  charged  to  an  account  in  the  general  ledger  known  as 
"petty  cash  fund"  and  stands  undisturbed  from  month  to 
month. 

The  petty  cashier  keeps  a  cash  book  provided  with  a  column 
for  each  of  the  principal  expense  items,  such  as  office  supplies, 
factory  supplies,  postage,  stationery,  and  printing,  etc.  He 
continues  to  pay  from  his  cash  fund  until  the  balance  gets  low,  or 
until  the  end  of  the  month,  when  he  rules  off  his  book,  presents 
it  to  the  cashier  together  with  his  vouchers,  and  receives  in  ex- 


THE  DETAILED  AUDIT  549 

change  a  cheque  for  the  exact  amount  of  his  expenses.  This  plus 
whatever  cash  balance  he  has  left  equals  the  original  petty  cash 
fund.  The  general  cashier  in  recording  the  cheque  on  his  records 
does  not  charge  "petty  cash";  instead  he  charges  the  various 
expense  accounts  direct,  posting  from  the  footings  of  the  columns 
in  the  petty  cash  book. 

Sometimes  a  loose  summary  sheet  to  which  the  vouchers  are 
attached  is  used.  On  this  they  are  entered  in  detail.  This 
system  does  away  entirely  with  the  petty  cash  book.  The  sum- 
mary sheet  and  supporting  vouchers  become  the  authority  for 
the  issuance  of  a  refunding  cheque  to  the  petty  cashier. 

Journal  Vouchers 

Vouchers  should  be  submitted  for  all  journal  entries  and  the 
auditor  need  not  announce  in  advance  how  many  of  them  he 
intends  to  inspect.  If  formal  vouchers  have  not  been  taken,  the 
journal  should  be  read  over  carefully  and  all  entries  for  which 
authority  should  have  been  secured  should  be  pointed  out  as 
requiring  proof. 

The  journal  can  be  used  fraudulently  by  making  in  it  fictitious 
or  irregular  credits  to  customers  or  other  personal  accounts  to 
conceal  the  misappropriation  of  cash  collected  therefrom.  To 
detect  this,  all  credits  to  customers  for  allowances,  returns,  etc., 
and  all  accounts  charged  off  as  bad  should  be  approved  by  some 
authorized  official.  If  no  such  approval  appears,  the  auditor 
should  ask  that  the  journal  entries  themselves  be  initialed.  Other 
credits  to  personal  accounts  are  made  for  salesmen's  expenses, 
etc.  These  should  be  verified  in  the  same  manner  as  cash 
vouchers. 

Well-managed  concerns  now  supply  their  salesmen  with  a 
fixed  fund,  and  payments  for  expenses  cover  the  exact  expendi- 
tures during  a  given  period.  This  obviates  the  necessity  for 
paying  out  round  sums  after  the  first  item.  Subsequent  pay- 
ments can  be  charged  direct  to  the  proper  expense  account  and 
thus  journal  entries  are  obviated. 


550  AUDITING— GENERAL  PRINCIPLES 

Transfers  from  one  account  to  another  may  be  for  the  pur- 
pose of  fraudulently  increasing  one  account  or  decreasing  another. 

The  experienced  auditor  need  not  spend  very  much  time  on 
the  journal,  since  a  careful  glance  over  the  pages  will  develop  any 
entries  which  require  explanation.  The  inexperienced  auditor 
should  examine  the  entries  carefully  and  call  for  documentary 
evidence  to  support  an  item  which  by  any  chance  might  be 
irregular. 

There  is  a  growing  tendency  on  the  part  of  bookkeepers  to 
use  a  printed  form  for  journal  vouchers  which  serves  in  most 
cases  as  a  memorandum  from  which  the  actual  book  entry  is 
made.  Consequently,  every  entry  is  duplicated.  One,  however, 
is  called  a  voucher,  although  it  may  not  be  approved  or  have 
attached  any  evidence  of  its  authenticity.  If  such  a  form  is 
used,  any  papers  or  documents  relating  thereto,  such  as  original 
correspondence  from  attorneys  stating  that  an  account  is  worth- 
less, etc.,  should  be  attached.  If  founded  on  the  action  of  a  com- 
mittee or  board  of  directors,  reference  should  be  made  to  the  page 
of  the  minute  book  where  recorded.  If  reference  is  made  to  a 
contract  or  agreement,  the  file  or  location  of  the  original  docu- 
ment should  be  stated. 

Cancellation  of  Vouchers 

Instances  are  known  where  dishonest  clerks  have  used  old 
vouchers  to  support  fictitious  dupHcate  payments,  altering  the 
dates  thereof.  It  is  important  that  an  auditor  mark  a  voucher 
in  such  a  way  that  it  cannot  possibly  be  presented  or  used  again. 

If  clients  insist  that  the  auditor  must  not  mark  or  deface  the 
vouchers,  it  is  difficult  to  guard  against  their  being  presented 
again,  with  a  change  of  date,  for  instance.  In  view  of  this  possi- 
bility the  auditor  should  scrutinize  the  vouchers  very  carefully 
and  lay  aside  for  special  investigation  any  which  bear  signs  of 
alteration.  If  possible,  all  vouchers  for  the  period  under  audit 
should  be  retained  in  the  custody  of  the  auditor  until  all  have 
been  examined.     If  vouchers  are  numbered  consecutively  and  if 


THE  DETAILED  AUDIT  551 

the  auditor  keeps  a  memorandum  of  the  serial  numbers  of  those 
examined,  subsequent  attempted  duplication  may  thus  be 
disclosed. 

The  best  method  of  cancellation  is  to  use  a  rubber  stamp 
bearing  the  name  of  the  auditor  and  the  initial  or  number  of  the 
clerk  in  charge  of  the  audit.  Some  auditors  use  a  conductor's 
punch. 

The  book  entries  should  be  marked  in  some  distinctive  way 
to  indicate  that  a  voucher  therefor  has  been  compared  with  the 
entry,  and,  since  the  voucher  may  be  more  or  less  incomplete,  it 
is  wise  to  use  different  marks  or  initials  to  indicate  the  kind  of 
voucher  submitted.  Each  auditor  should  select  his  own  marks. 
It  is  advisable  to  change  them  from  time  to  time  as  the  client's 
clerks  become  familiar  with  the  marks  and  with  the  procedure 
of  a  routine  audit. 

MISCELLANEOUS   EXPENDITURES 

It  is  reiterated  that  substance,  not  form,  is  the  keynote  of  the 
verification  of  expenditures.  There  will  now  be  discussed  some 
of  the  major  classes  of  costs  and  expenses.  In  passing  upon  them 
intelligently  rather  than  mechanically,  the  auditor  has  an  oppor- 
tunity to  render  constructive  service. 

Repairs  and  Renewals 

In  the  audit  of  a  large  manufacturing  establishment  this  is 
the  most  troublesome  account  which  the  auditor  is  called  to  pass 
upon. 

The  underlying  purpose  of  the  audit  of  expenses  is  to  ascer- 
tain as  far  as  possible  that  an  equivalent  was  received  for  the 
liability  assumed,  but  the  improper  application  in  the  books  of 
the  expenditure  for  repairs  and  maintenance  may  upset  the  ac- 
curacy of  a  balance  sheet  in  spite  of  the  fact  that  value  was  re- 
ceived for  the  liability  assumed.  That  is,  the  expenditure  for 
repairs  or  for  renewals  may  be  charged  to  plant  or  some  other 


552  AUDITING— GENERAL  PRINCIPLES 

asset  account  instead  of  to  current  operating  expense,  thus  in- 
flating the  assets  on  the  one  hand  and  the  profits  on  the  other. 
It  must  be  kept  in  mind  constantly  that  tacit  conspiracy  usually 
exists  to  bring  about  this  very  result,  and  so  the  auditor  is  apt  to 
find  strong  forces  arrayed  against  him  as  soon  as  an  accurate 
accounting  for  maintenance  items  is  begun. 

This  tendency  has  been  almost  completely  reversed  since  the 
enactment  of  the  income  and  excess  profits  laws.  This  is  true 
to  such  an  extent,  indeed,  that  not  only  are  all  repairs  and  re- 
newals charged  to  expenses,  as  they  should  be,  but  sometimes 
items  which  are  clearly  additions  and  which  should  be  capitalized 
are  likewise  charged  to  expenses. 

In  some  plants  the  necessity  for  repairs  and  renewals  is  so 
constant  that  the  aggregate  cost  appears  at  about  the  same  figure 
from  year  to  year.  In  other  plants  the  item  is  a  fluctuating  one. 
In  the  latter  case  there  is  no  objection  to  setting  aside  a  fixed 
annual  sum  based  on  the  average  over  a  period  of  years,  and 
charging  against  the  account  the  actual  expenditures  for  repairs 
and  renewals. 

Care  should  be  taken,  in  establishing  such  a  policy,  to  com- 
mence it  when  repairs  are  under  the  average.  The  balance  unex- 
pended at  the  end  of  the  first  year  should  be  carried  over  as  a 
reserve,  and  at  no  time  should  the  account  show  a  debit  balance 
or  be  carried  as  a  deferred  asset.  If  the  account  shows  a  debit 
at  any  time,  the  debit  should  be  transferred  to  income,  or  the 
periodical  credits  to  the  reserve  increased. 

The  ordinary  manager,  superintendent,  or  foreman  seems  to 
feel  that  it  is  a  reflection  on  him  individually  or  on  his  depart- 
ment to  incur  any  considerable  expense  on  renewals  and  repairs. 
He  knows  this  will  increase  his  cost  of  operating.  He  knows, 
too,  that  an  item  charged  to  an  asset  account  will  not  be  charged 
against  him ;  so  it  is  no  wonder  that  an  analysis  of  plant  accounts 
sometimes  discloses  remarkable  items  which  are  in  no  sense  of  the 
word  betterments,  but  current  maintenance. 

In  order  to  make  a  complete  audit  of  items  which  should  be 


THE  DETAILED  AUDIT  553 

charged  to  repairs,   the  charges  to  plant  accounts  must   be 
analyzed. 

Renewals  Necessitated  by  Inadequacy. — When  new 
buildings  or  equipment  are  substituted  for  old,  before  the  old 
buildings  or  equipment  have  been  fully  depreciated,  the  book 
cost  of  the  new  must  not  include  the  residual  value  of  the  assets 
discarded.  In  estimating  the  cost  of  new  projects,  losses  due  to 
abandonment  before  effective  life  has  expired  usually  are  taken 
into  consideration.  The  abandoned  plant,  however,  cannot 
benefit  any  subsequent  period,  therefore  the  application  of  the 
rule  that  deferred  items  must  carry  a  benefit  prevents  the  capital- 
ization of  the  residual  values.  Also,  from  another  point  of  view, 
it  is  not  proper  to  capitalize  past  losses;  competing  concerns  mak- 
ing new  installations  of  identical  plant  will  have  a  lower  book 
cost  and  lower  depreciation  charges  than  the  concern  which 
capitalizes  abandoned  plant.  The  subject  must  be  dealt  with 
under  the  reasoning  that  the  combined  depreciation  and  obso- 
lescence allowances  of  the  original  cost  were  too  low,  otherwise 
the  book  value  of  the  abandoned  plant  would  be  written  off. 
Failure  to  provide  adequate  allowances  is  a  mistake  of  the  past 
and  must  be  charged  off  when  discovered.  It  is  not  fair  to  future 
operations  to  carry  over  the  mistakes  of  the  past. 

Allowances  and  Returns 

There  are  two  very  good  reasons  for  a  careful  scrutiny  of  all 
credits  to  customers.  The  first  is  that  by  means  of  unauthorized 
credits  fraud  may  be  concealed.  That  is,  cash  collected  from  a 
customer  is  not  accounted  for,  and  subsequently,  to  avoid  dis- 
covery, the  ledger  account  is  closed  by  an  entry  which  indicates 
that  goods  have  been  returned  or  that  an  allowance  has  been 
made. 

The  second  reason  is  that  in  the  absence  of  fraud  there  may 
be  carelessness  both  in  the  manner  of  granting  credit  for  allow- 
ances and  returns  and  in  the  record  thereof.     For  instance,  some 


554  AUDITING— GENERAL  PRINCIPLES 

automobile  dealers  deduct  freight  from  credits  for  returned 
defective  parts;  others  do  not.  To  a  dealer  doing  a  large  busi- 
ness this  makes  a  difference  of  several  hundred  dollars  a  year. 

In  some  concerns  full  credit  is  not  given  when  goods  are 
returned,  simply  because  an  overstock  exists.  In  others,  there  is 
little  or  no  check  on  the  returns  and  full  credit  is  allowed. 

The  auditor  should  therefore  examine  the  record  which  has 
been  kept  and  ascertain  that  so  far  as  possible  the  entries  are  ap- 
proved by  some  responsible  official  and  that  no  abuse  has  been 
made  of  the  return  privilege.  In  order  to  test  the  integrity  of  the 
entries,  it  may  be  desirable  to  call  for  the  correspondence  in 
connection  with  a  certain  number  of  items. 

Goods  returned  are  not  purchases,  but  deductions  from  sales, 
but  so  far  as  stock  records  are  concerned  they  should  be  treated 
like  purchases  and  tests  should  be  made  to  see  that  the  entries 
in  the  return  book  are  posted  to  the  stock  sheets  as  regularly  as 
those  in  the  purchase  records.  Otherwise  an  opportunity  may  be 
afforded  to  a  stock  clerk  to  ship  goods  without  accounting 
for  them. 

Separate  columns  should  be  kept  in  the  allowance  and  return 
book,  since  allowances  may  or  may  not  be  posted  to  a  separate 
ledger  accoimt,  whereas  returns  are  always  deductible  from  sales. 

The  newspapers  recently  reported  a  case  wherein  it  appeared 
that  the  bookkeeper  of  a  baking  company  had  manipulated 
his  books  by  crediting  customers  with  excessive  returns.  The 
following  is  the  police  account,  in  part: 

He  (bookkeeper)  left  the  firm  the  early  part  of  this  month,  and  when 
his  books  were  examined,  the  firm  found  a  shortage  of  more  than  $1,500. 
He  admitted  entering  in  the  books  to  the  credit  of  customers  a  greater 
number  of  loaves  of  bread  daily  than  were  actually  returned  by  the  firm's 
drivers. 

Purchase  Returns. — The  return  of  goods  which  have  been 
purchased  and  received  is  no  part  of  the  normal  conduct  of  a 
business.     For  this  reason,  when  goods  are  returned  because 


THE  DETAILED  AUDIT  555 

they  are  defective  or  unsatisfactory,  or  because  they  were  not 
ordered,  etc.,  the  record  of  such  returns  is  not  always  a  perma- 
nent or  satisfactory  one. 

In  most  cases  dependence  is  placed  on  a  memorandum  made 
on  the  original  invoice.  If  made  before  the  invoice  is  entered  on 
the  books,  it  is  practically  sure  to  prevent  payment,  but  some- 
times the  invoice  will  have  been  entered,  and  if  care  is  not  taken, 
the  account  will  be  paid  in  due  course  without  making  any  de- 
duction for  returns.  The  best  preventive  of  such  omissions  is  to 
have  a  good-sized  book  labeled  plainly,  *' Returned  Purchases," 
in  which  is  entered  a  memorandum  covering  every  return.  This 
book  should  be  compared  with  the  purchase  books  regularly  to 
prevent  errors  in  payments. 

Containers 

In  many  lines  of  business  shipments  are  made  in  bottles, 
boxes,  barrels,  or  other  forms  of  containers,  which  have  a  residual 
value.  The  test  of  this  residual  value  is  the  cost  of  the  container, 
its  durability,  and  the  expense  of  return.  When  no  charge  is 
made  for  the  container  and  credit  is  allowed  for  it  when  returned, 
such  return  is  equivalent  to  a  purchase,  provided  the  allowance 
is  not  more  than  the  open  market  price.  If  the  credit  is  at  a 
higher  price  than  the  market,  the  excess  is  clearly  a  deduction 
from  sales.  If  credit  is  passed  only  upon  return  and  if  the  allow- 
ance is  not  more  than  cost,  no  record  need  be  kept  of  those  out- 
standing, since  it  makes  no  difference  whether  or  not  they  are 
returned.  If  a  separate  charge  for  containers  appears  on  the  in- 
voices and  if  the  information  is  of  value,  it  is  possible  to  keep 
track  of  the  aggregate  charged  for  and  the  aggregate  returned 
without  difficulty. 

In  case  of  kegs,  crates,  s)^hons,  etc.,  for  which  no  charge  is 
made,  but  which  must  be  returned,  the  most  common,  and  prob- 
ably the  most  satisfactory,  method  of  handling  is  to  note  the 
quantities  in  the  sales  book  and  post  the  items  to  the  customers 
ledger,  in  which  a  special  column  should  be  provided  on  both 


556  AUDITING— GENERAL  PRINCIPLES 

debit  and  credit  sides.  If  this  system  has  not  been  in  force,  a 
very  careful  test  of  the  records  should  be  made,  as  errors  usually 
exist  which  may  be  unnecessary  as  well  as  expensive. 

The  method  of  inspection  and  of  passing  credit  should  have 
the  auditor's  attention.  If  the  receiving  clerk  is  careless  or  in- 
efficient, the  number  of  containers  returned  may  not  be  verified, 
and  damaged  or  broken  containers  may  be  passed  as  in  good 
condition.  The  clerk  in  charge  of  the  credits  should  not  be 
allowed  to  settle  the  custom  of  the  house  with  respect  to  prices 
to  be  allowed,  freight  payments,  etc. 

If  containers  are  charged  to  customers  at  a  substantial  in- 
crease over  cost,  and  if  permission  is  granted  for  return  at  the 
same  price,  the  auditor  must  provide  a  reserve  to  cover  outstand- 
ings when  the  books  are  closed.  The  auditor  should  also 
consider  the  question  of  the  depreciation  of  the  containers  which 
may  be  returned  as  well  as  that  of  those  on  hand. 

Where  containers  are  furnished  free  with  an  obligation  to 
return,  it  must  be  assumed  that  customers  treat  the  obligation 
lightly  and  that  a  considerable  proportion  will  not  be  accoimted 
for,  in  addition  to  the  usual  losses  and  breakages.  If  feasible, 
an  attempt  should  be  made  at  some  convenient  time  to  secure  an 
actual  inventory  of  containers  on  hand  and  within  reach  which 
are  positively  known  to  be  recoverable.  A  comparison  of  these 
figures  with  the  book  inventory  forms  a  sound  basis  for  a 
depreciation  or  expense  rate. 

Salaries 

In  all  cases  a  pay-roll  book  showing  names,  positions,  and 
salary  rates  of  all  employees  should  be  kept.  This  does  not 
include  workmen  and  others  whose  compensation  is  referred  to 
throughout  this  book  as  wages. 

The  pay-roll  book  should  be  arranged  with  thirteen  columns, 
to  cover  three  months'  time.  Each  column  should  be  initialed  by 
an  executive.  The  cashier  should  have  written  authority  for  each 
change  in  rate  and  for  each  name  added.     If  one  cheque  is  drawn 


THE  DETAILED  AUDIT  557 

for  an  entire  pay-roll,  the  auditor  should  verify  the  footings  of, 
say,  every  third  week. 

Employees'  Bonds. — In  considering  the  question  of  relations 
to  employees,  the  auditor  should  always  include  in  his  audit 
program  the  query:  "Are  all  employees  who  handle  funds  under 
surety  bonds?''  If  not,  they  should  be.  Some  employers  are 
lax  in  this  respect,  others  will  not  incur  the  expense,  and  a  fairly 
large  class  dislike  to  mention  the  matter  to  employees  who  have 
occupied  positions  of  trust  for  a  number  of  years. 

The  auditor  should  present  the  importance  of  such  protection 
and  point  out  that  the  expense  is  comparatively  small,  but  that 
the  risk  is  a  real  one.  Of  course  the  auditor  has  performed  his 
full  duty  after  his  recommendation  has  been  considered,  and  if 
nothing  is  done  he  cannot  be  blamed  for  subsequent  loss. 

It  may  be,  however,  that  the  matter  should  be  given  con- 
sideration at  each  audit  because  conditions  and  employees 
change.  It  might  not  be  difficult  to  persuade  an  employer  to 
adopt  a  rule  that  every  new  employee  should  furnish  a  bond  at 
the  time  of  employment.  This  means  that  in  time  the  entire 
staff  would  be  bonded.  In  every  case  the  employer  should  pay 
the  premium. 

'  Many  employers  find  it  desirable  to  insist  that  practically 
their  entire  force,  including  salesmen,  furnish  a  surety  bond.  The 
reason  given  is  that  all  of  them  handle  funds  at  one  time  or  an- 
other. It  makes  it  easier  to  demand  bonds  from  cashiers  when 
the  rule  is  general,  and  a  lower  rate  can  be  secured  when  several 
persons  are  covered  by  one  bond.  The  chief  value,  however,  in 
requiring  bonds  from  salesmen  is  that  the  employer  is  assured 
that  a  most  exhaustive  inquiry  is  made  into  each  applicant's 
character  and  reputation,  extending  back  over  a  considerable 
period  of  years.  This  search  is  far  more  extensive  than  an  em- 
ployer can,  or  cares  to,  make  himself,  and  since  such  a  bond  for, 
say,  $500  does  not  cost  more  than  $2  or  $3,  it  is  well  worth  a  trial. 
Salesmen  are  usually  intrusted  with  funds  to  pay  traveling  ex- 


558  AUDITING— GENERAL  PRINCIPLES 

penseSj  and  similar  funds  are  placed  at  the  disposal  of  other 
employees. 

Inability  to  secure  a  bond  should  be  considered  a  prima  facie 
reason  for  non-employment,  or  dismissal,  and  a  good  reason  must 
be  furnished  to  offset  the  effect  of  the  refusal  of  the  surety 
company. 

It  is  obvious  that  a  man  who  cannot  furnish  a  $500  surety 
company  bond  is  not  a  desirable  clerk. 

Does  Not  Obviate  Audit. — Employers  sometimes  think 
that  placing  an  employee  under  bond  in  some  way  obviates  the 
necessity  for  an  audit.  As  a  matter  of  fact,  this  precaution  is  all 
the  more  advisable  because  a  means  is  provided  for  recouping 
the  amount  misappropriated,  if  a  defalcation  does  occur.  The 
surety  companies  themselves  advocate  periodical  audits.  One 
of  the  leading  bonding  companies  in  America,  says : 

Frequent,  regular,  and  thorough  audits  of  cash  and  books  of  account 
by  certified  public  accountants  are  unquestionably  of  the  greatest  benefit 
to  the  business  man  and  institution,  and  should  be  universally  adopted. 

We  cannot  put  what  we  state  above  too  emphatically,  and  it  is  deserv- 
ing of  the  serious  consideration  of  every  business  man. 

An  agent  of  a  surety  company  wrote  as  follows  in  declining  an 
application  for  a  bond: 

The  employer's  statement  says  that  the  applicant's  accounts  will  be 
examined  monthly  by  an  officer  of  the  corporation.    The  ......   Company 

advise  us  that  this  is  not,  in  their  opinion,  a  complete  or  thorough  check 
of  the  applicant's  accounts,  and  they  would  prefer  that  the  accounts  be 
examined  by  a  certified  public  accountant. 

The  surety  companies  frequently  quote  their  minimum  rates 
where  they  find  that  the  books  are  regularly  audited  by  profes- 
sional auditors  in  whom  they  have  confidence,  and  this  may 
represent  a  considerable  saving  to  the  assured. 

Save  or  Quit! — ^Another  point  in  connection  with  the  rela- 
tion between  employer  and  employed  is  that  of  the  financial 


THE  DETAILED  AUDIT  559 

condition  of  the  clerk  who  handles  or  has  access  to  funds  or 
personal  property  of  value.  Defalcations  are  usually  preceded 
by  living  beyond  one's  means,  and  this  fact  is  frequently  known 
to  an  employer.  There  are  many  legitimate  and  deserving  cases 
where  clerks  find  themselves  in  debt.  If  honest,  they  will  en- 
deavor to  get  out  of  debt  by  reducing  their  expenses.  In  any 
event  there  is  a  loss  in  efficiency  wherever  a  clerk  is  living  beyond 
his  means.  It  must  be  on  his  mind  to  the  detriment  of  his  work. 
The  employer  who  permits  his  clerks  to  overdraw  their  salaries, 
or  who  is  indifferent  to  evidences  of  extravagance,  will  surely 
suffer  in  the  end.  It  is  not  out  of  place  for  an  auditor  to  remind 
him  that  the  case  of  any  employee  who  is  not  saving  money 
requires  attention. 

The  author  has  known  of  cases  where  one  man,  holding  a 
responsible  position  in  an  office,  failed  in  his  own  duty  and  was 
the  cause  of  his  subordinates  failing  in  theirs,  because  he  lived 
beyond  his  means  and  his  financial  difficulties  worried  him  and 
made  him  inefficient.  It  would  have  been  cheaper  to  pay  him 
his  full  salary  to  stay  away  from  the  office. 

Salesmen's  Commissions 

Examine  contracts  and  note  provisions  as  to  percentage, 
territory,  and  particularly  as  to  whether  commissions  are  payable 
on  dehvery  of  goods  or  on  collection  of  accounts;  also  whether 
commissions  are  based  on  gross  sales  or  on  net  proceeds  after 
deductions  for  cash  discoimts,  freight,  etc. 

Traveling  Expenses,  Entertaining,  etc. 

Examine  contracts  of  salesmen  to  see  if  a  limit  has  been  placed 
on  traveling  and  other  expenses.  If  contracts  are  not  required, 
inquire  of  the  manager  whether  any  understanding  of  this  nature 
is  in  force. 

In  many  concerns  the  utmost  liberality  prevails  in  such  al- 
lowances, but  sentiment  along  these  lines  is  changing  and  sales- 
men are  now  being  held  to  a  stricter  accountabihty  than  f ormerlyc 


56o  AUDITING— GENERAL  PRINCIPLES 

The  auditor,  therefore,  should  take  pains  to  make  inquiries  on 
this  point  at  each  audit. 

Vouchers  for  traveling  and  similar  expenses  should  be 
approved  by  someone  in  authority. 

A  railroad  employee  whose  duty  it  was  to  prepare  the 
vouchers  for  traveling  expenses  was  recently  convicted  of  padding 
the  expense  accoimts  of  officers  of  the  road.  By  clever  duplica- 
tion of  half  a  dozen  signatures,  fictitious  vouchers  covering  ficti- 
tious expense  accounts  were  prepared.  These  were  then  pre- 
sented, approved,  and  the  amounts  collected.  When  arrested, 
the  employee  complained  that  the  railroad  paid  him  only  $ioo 
a  month,  although  his  predecessor  had  received  $175.  His  thefts 
aggregated  about  $5,000  over  a  period  of  two  or  three  years. 

The  auditor  is  interested  in  seeing  that  railroad  mileage  is 
properly  accounted  for.  Mileage  may  be  carried  as  a  separate 
account  on  the  ledger,  if  it  is  large,  or  it  may  be  regarded  as  cash 
and  included  in  the  cash  figures.  When  it  is  given  out,  the  full 
amount  in  the  book  is  charged  at  cost  against  the  traveling 
advance  account  of  the  one  who  is  using  it.  When  it  is  returned, 
credit  is  given  just  as  if  cash  were  returned. 

Wages 

In  the  audit  of  a  business  having  many  employees,  it  is  neces- 
sary to  devote  some  time  to  a  consideration  of  the  system  of  time 
records  and  wage  payments.  It  is  a  well-known  fact  that  re- 
ceipts are  worthless  as  a  check  on  the  amounts  paid.  It  may  be 
desirable  for  a  concern  to  have  a  receipt  from  each  man  to  enable 
it  to  guard  against  subsequent  disputes,  but  these  receipts  are 
of  little  real  value  to  an  auditor  who  is  attempting  to  prove  to 
his  own  satisfaction  that  the  aggregate  amounts  of  the  pay-roll 
payments  have  reached  the  hands  of  those  entitled  to  them. 

The  auditor  must  think  this  out  for  himself  in  each  audit,  but 
it  is  suggested  that  the  best  check  on  wage  payments  is  for  the 
client  to  use  as  many  people  as  possible  during  the  various  stages 
from  the  point  where  the  time  is  recorded  to  the  final  handing 


THE  DETAILED  AUDIT  5^1 

out  of  the  envelopes.  If  the  latter,  for  instance,  is  done  by  an 
employee  who  has  no  access  to  the  rolls  or  to  the  cash,  it  makes  a 
good  check.  If  an  auditor  is  on  hand  when  the  men  are  being 
paid  off,  he  should  supervise  the  operation  or  even  take  a  more 
active  part,  if  feasible.  Obviously,  this  procedure  is  of  no  value 
unless  it  is  done  without  notice  to  anyone. 

A  few  large  corporations  have  tried  the  experiment  of  paying 
exclusively  by  cheque,  but  it  is  believed  that  the  plan  has  been 
abandoned  by  most  of  them. 

Points  to  Be  Considered. — The  auditor  must  direct  his 
attention  to  two  main  points,  viz.,  the  records,  which  may  be 
kept  accurately  or  inaccurately,  and  the  clerical  force  in  charge 
of  the  records,  who  may  be  honest  or  dishonest.  Fortunately 
for  employers,  most  of  the  records  now  in  general  use  are,  or 
should  be,  mechanical  or  automatic.  The  time  clock  registers 
the  time  in  and  out,  and  other  devices  stamp  the  time  actually 
employed  on  various  jobs..  In  the  office  these  records  in  turn  are 
checked  and  proved  by  mechanical  means. 

The  audit  of  wages  earned  therefore  resolves  itself  into  a 
critical  inspection  of  the  system  in  use.  Before  making  this  in- 
spection, the  auditor  should  acquaint  himself  with  the  particulars 
of  all  the  latest  devices  on  the  market.  He  can  then  evince  a 
famiharity  with  any  system  he  finds  and  note  any  lack  of  effi- 
ciency, and  is  also  in  a  better  position  to  make  suggestions  where 
unsatisfactory  methods  are  found. 

Management. — The  author  feels  that  the  scope  of  this  book 
is  too  limited  to  contain  directions  as  to  the  best  system,  except 
to  suggest  that,  since  scientific  management  has  taken  hold  of  the 
labor  question  so  seriously,  and  has  been  more  or  less  successful, 
the  auditor  who  has  to  deal  with  the  audit  of  wages  paid,  and  who 
is  expected  to  criticize  the  records  relating  thereto,  owes  to  him- 
self and  his  profession  the  duty  of  at  least  reading  the  best-known 
books  on  factory  management,  and  of  glancing  over  the  descrip- 
tive circulars  of  some  of  the  really  wonderful  mechanical  appli- 


562  AUDITING— GENERAL  PRINCIPLES 

ances  designed  especially  by  experts  familiar  with  the  practical 
side  of  the  question.     So  much  for  the  system. 

The  personnel  and  the  extent  of  the  clerical  force  are  impor- 
tant from  the  auditor's  point  of  view.  He  should  be  especially 
vigilant  in  small  establishments  where  the  office  force  is  small 
and  where  the  same  clerk  keeps  or  assists  with  the  original 
records,  makes  up  or  assists  with  the  envelopes,  and  distributes 
them  or  has  some  connection  with  their  distribution. 

Illustrations. — Concrete  instances  may  serve  better  than 
theory  in  pointing  out  the  course  the  auditor  should  take  to 
satisfy  himself  that  the  pay-rolls  are  correct. 

The  auditor  should  ascertain  that  the  names  of  discharged 
men  are  removed  from  the  pay-roll  as  of  the  proper  date.  In  a 
large  factory  the  foreman  handed  in  to  a  clerk  in  the  office  who 
had  access  to  the  pay-rolls,  slips  bearing  the  names  of  men  dis- 
charged. The  clerk  destroyed  the  slips  and  recorded  full  time 
to  the  credit  of  the  men  discharged.  In  paying  off  he  secured 
the  envelopes  and  retained  the  money.  The  fraud  was  not 
discovered  for  a  long  time. 

In  a  factory  where  time  books  were  kept  by  the  foreman,  the 
assistant  cashier  transferred  the  time  therein  to  the  pay-roll 
book.  In  addition,  he  entered  several  fictitious  names.  The 
cashier  himself  made  up  the  envelopes  and  superintended  the 
paying  off.  Each  week  a  number  of  envelopes  were  left  over,  as 
is  nearly  always  the  case  in  a  large  plant,  on  account  of  sickness, 
etc.  Most  of  them  are  called  for  within  a  short  time.  In  this 
case  the  dishonest  clerk  always  had  an  opportunity  to  secure 
the  envelopes  covering  the  fictitious  names.  The  auditor  dis- 
covered the  fraud  by  calling  in  the  time  books  and  comparing 
them  with  the  pay-roll. 

A  defalcation  of  over  $30,000  came  to  light  when  a  proprietor 
paid  off  his  employees  in  the  absence  of  the  pay-roll  supervisor, 
who  was  an  old  and  trusted  employee.  The  proprietor's  sus- 
picions were  aroused  when  someone  who  was  not  known  to  the 


THE  DETAILED  AUDIT  5^3 

proprietor  presented  a  pay  check.     It  developed  that  the  pay- 
roll supervisor  had  been  falsifying  the  pay  records  for  some  time. 

Customs  Duties 

The  vouching  of  duties  requires  great  care,  because,  until  re- 
cently, collectors  of  internal  revenue  would  not  accept  cheques 
in  payment,  but  insisted  on  legal  tender.  If  such  payments  are 
few  in  number,  they  are  usually  made  through  a  custom  house 
broker,  and  his  invoices,  if  properly  checked  and  approved,  are 
sufficient  evidence  of  the  propriety  of  the  payments. 

In  any  event,  the  auditor  should  inquire  into  the  procedure 
in  force  and  satisfy  himself  that  the  matter  is  properly  handled. 
Instances  have  been  known  where  everything  was  left  to  clerks 
who  did  not  have  skill  enough  to  find  errors  when  they  did  exist. 

Interest  and  Collection  Charges 

Too  much  confidence  is  placed  in  the  accuracy  of  bank 
clerks;  therefore  it  is  usually  found  that  interest  charged  on  loans 
and  credited  on  deposit  balances,  discoimt  deducted,  and  collec- 
tion fees  charged  are,  in  nine  cases  out  of  ten,  accepted  as  final 
without  being  checked  by  the  cHent's  staff.  Auditors  whose 
experience  includes  much  bank  work  are  familiar  with  the 
numerous  errors  made  by  bank  clerks  in  their  own  records;  and 
while  perhaps  a  majority  of  bank  officers  insist  on  these  errors 
being  located  and  corrected,  yet  it  is  obvious  that  in  calculations 
involving  interest  and  collection  charges  or  credits,  there  is  not 
the  same  likelihood  of  the  correction  of  errors  as  exists  with  those 
items  which  enter  into  the  regular  double-entry  system  of  the 
bank. 

It  follows  that  many  errors  are  made  and  remain  unaetected 
imless  the  auditor  tests  the  items.  But  the  auditor  should  not 
stop  with  the  verification  of  the  calculations.  Banks  charge  as 
high  an  interest  rate  on  loans  and  discounts  as  they  think  the 
traffic  will  bear,  and  if  an  auditor  finds  that  a  concern  with  first- 
class  credit  is  being  charged  6  per  cent,  when  he  knows  that  other 


5^4  AUDITING— GENERAL  PRINCIPLES 

concerns  of  equal  or  inferior  standing  are  paying  41/2  or  5  per 
cent,  it  is  certainly  in  order  to  mention  the  matter  when  a  good 
opportunity  arises.  The  successful  auditor  does  not  lose  any 
good  chance  to  render  a  service  which  falls  within  the  scope  of  a 
business  adviser. 

Some  banks  require  borrowers  to  keep  a  part  of  the  amoimt 
loaned,  generally  20  per  cent,  continuously  on  deposit  until  the 
loan  is  repaid.  This  practically  means  that  the  rate  of  interest 
is  increased,  say,  one-fourth.  The  auditor  should  in  such  cases 
ascertain  whether  the  client  can  borrow,  or  is  borrowing,  on  a 
more  advantageous  basis  from  some  other  institution.  It  may 
be  that  only  one  of  several  banks  loaning  to  the  client  makes 
such  conditions,  in  which  case  the  client's  attention  should  be 
called  to  the  advisability  of  transferring  his  loans  to  some  other 
institution. 

Insurance  Premiums 

Experience  shows  that  the  bills  of  insurance  agents  are  rarely 
scrutinized  unless  the  item  of  premiums  is  a  very  large  one  and 
the  bill  is  in  charge  of  someone  especially  designated  to  keep 
track  of  the  insurance  in  force  and  the  rates  charged  for  insurance. 
For  this  reason  a  careful  audit  of  the  premium  bills  and  a  careful 
analysis  of  the  total  insurance  carried  is  a  fruitful  field  of  in- 
quiry for  the  auditor,  and  particularly  advisable  in  audits  where 
great  care  is  taken  with  other  classes  of  expenses. 

In  one  case  an  auditor  noticed  that  a  policy  had  been  canceled 
and  another  company  substituted.  He  looked  for  a  credit  to 
cover  the  return  premium  on  the  canceled  policy,  but  failed  to 
find  it.  This  started  a  complete  investigation  into  insurance 
matters,  and  it  was  found  that  for  several  years  back  one  or  more 
policies  had  been  canceled  each  month,  due  to  the  undesira- 
bility  of  the  risk,  but  that  no  credit  therefor  had  been  issued  by 
the  agent.  The  total  amount  recovered  amotmted  to  several 
himdred  dollars  and  the  discovery  greatly  enhanced  the  auditor's 
reputation. 


THE  DETAILED  AUDIT  5^5 

Amount  of  Insurance. — Sufficient  attention  is  not  paid  to 
the  amount  of  insurance  carried.  If  overinsured,  a  useless 
expense  is  incurred,  and  if  underinsured,  an  unjustifiable  risk  is 
assumed.  The  matter  is  one  requiring  comparatively  little  time, 
perhaps  not  so  much  as  to  verify  the  footings  or  postings  for  a 
short  period,  and  is  of  very  much  more  importance. 

Coinsurance  Clause. — Insurance  policies  generally  contain  a 
coinsurance  clause  which  stipulates  that  unless  the  risk  is  in- 
sured for,  say,  80  per  cent  of  its  value,  the  assured  is  a  coinsurer 
for  that  part  represented  by  the  difference  between  the  percentage 
insured  and  the  required  percentage.  Auditors  should  examine 
the  conditions  of  the  policies  in  each  case. 

Unexpired  Premiums. — As  stated  elsewhere,  the  unexpired 
portion  of  premiums  prepaid  at  the  date  of  the  balance  sheet  is  a 
deferred  asset.  In  a  going  business  it  is  proper  to  set  up  the  full 
unexpired  proportion  of  the  premiums  paid  in  advance,  but  in  a 
statement  of  affairs,  such  as  is  required  in  the  event  of  proposed  or 
forced  liquidation,  it  may  be  necessary  to  base  thfe  calculations 
upon  the  "short"  rates  which  are  used  in  the  cancellation  of 
policies. 

Refunds. — When  insurance  is  placed  with  mutual  insurance 
companies  and  a  nominal  amoimt  is  paid  as  an  original  premium 
with  the  understanding  that  the  proportionate  excess  of  receipts 
over  losses  and  expenses  shall  be  refunded,  .such  refunds  should  be 
deducted  from  the  original  premium  charged  and  the  net  amount 
considered  as  an  expense.  In  some  cases,  due  to  the  fact  that  a 
deposit  is  made  with  such  companies,  the  refunds  are  considered 
as  special  or  financial  income,  but  this  is  not  accurate,  since  only 
a  small  part  of  the  income  from  which  the  refund  is  paid  comes 
from  the  investment  of  the  deposits  mentioned.  ^ 

The  auditor  should  make  a  special  investigation  of  the  con- 
tract or  agreement  with  the  mutual  insurance  companies,  be- 
cause in  some  cases  there  are  special  contingent  liability  clauses 
in  such  contracts  or  agreements. 


566  AUDITING— GENERAL  PRINCIPLES 

Freight  and  Express 

Freight  is  another  class  of  expense  which  is  passed  by  many 
auditors  on  the  assumption  that  the  amounts  paid  are  sure  to  be 
accurate,  and  that  it  is  a  waste  of  time  to  attempt  to  go  into 
detail.  As  a  matter  of  fact,  transportation  companies,  and  par- 
ticularly express  companies,  are  chronic  overchargers,  and  every 
bill  must  be  checked  most  carefully. 

An  auditor  need  not  go  into  tariff  details,  but  he  should  inquire 
closely  into  the  method  of  check  in  use,  and  if  he  finds  that  the 
freight  and  express  bills  are  not  approved  as  to  weights  and  rates 
by  an  intelligent  clerk  who  uses  all  possible  sources  of  informa- 
tion to  secure  the  lowest  quotations,  he  will  probably  find  an 
opportunity  to  make  a  constructive  report  on  the  situation. 

Many  trades  have  a  central  association  with  a  traffic  bureau, 
which  furnishes  full  and  free  information  when  requested  to  do 
so  by  its  members.  The  Interstate  Commerce  Commission  will 
also  assist  a  shipper  who  feels  aggrieved. 

In  one  very  large  manufacturing  company  being  audited  for 
the  first  time  by  the  author's  firm,  it  was  found  that  practically 
no  attention  was  given  to  the  inspection  of  freight  bills,  it  being 
assumed  that  the  charges  were  always  in  order.  A  careful  test 
disclosed  the  fact  that  many  purchases  had  been  made  on  a  basis 
of  freight  being  prepaid  by  the  shipper.  Now  it  is  the  custom 
in  such  cases  for  the  consignee  to  pay  the  freight  and  to  deduct 
it  from  the  invoices.  The  company  under  audit  had  paid  the 
freight  in  every  case,  but  had  charged  it  to  purchases  account 
instead  of  to  the  shipper.  The  investigation  was  carried  back 
several  years  and  many  thousands  of  dollars  were  actually 
recovered. 

Postage 

Vouchers  should  be  secured  for  all  purchases  of  stamps. 
Postmasters  will  always  sign  receipts  when  requested  to  do  so. 
Defalcations  of  small  sums  are  frequently  found  in  connection 
with  postage  accounts,  so  that  an  auditor  should  not  only  scruti- 


THE  DETAILED  AUDIT  5^7 

nize  such  payments  very  carefully,  but  should  suggest  safeguards 
which  will  reduce  future  possibilities  of  loss,  and,  more  important 
still,  remove  a  serious  source  of  temptation  to  junior  clerks. 

There  should  be  some  relation  between  the  total  cost  of  post- 
age and  other  expense  accounts,  such  as  stationery  and  printing, 
advertising  circulars,  etc. 

A  post-office  regulation  is  that  bills  entirely  in  print,  with  the 
exception  of  the  names  of  the  addressee  and  sender,  are  third- 
class  matter,  and  when  sent  in  the  mails  unsealed,  are  chargeable 
with  postage  at  the  rate  of  one  cent  for  each  two  ounces  or  frac- 
tion thereof.  Bills  bearing  written  items,  amounts,  etc.,  are 
first-class  matter  and  chargeable  with  postage  at  the  rate  of  two 
cents  an  ounce  or  fraction  thereof.  ^ 

A  daily  mail  book  showing  the  total  postage  used  on  outgoing 
mail  requires  very  little  time  to  compile  and  is  valuable  for 
several  reasons.  It  affords  an  opportunity  to  apportion  the 
cost  to  various  accounts  and  has  a  most  excellent  moral  effect 
on  those  who  handle  the  stamps,  because  someone  in  authority 
from  each  department  should  initial  the  charges  to  such  depart- 
ment at  least  weekly. 

Inquiry  should  be  made  to  ascertain  if  postage  is  paid  on 
outgoing  shipments  of  goods  in  small  quantities.  Many  con- 
cerns add  postage  to  such  shipments,  and  custom  permits  it  unless 
quotations  are  made  ''prepaid."  If  not  so  made  and  a  consider- 
able number  of  shipments  are  made  by  mail,  it  will  be  in  order  for 
the  auditor  to  suggest  that  the  cost  of  the  postage  be  added  to  the 
invoice. 

In  one  instance,  where  quotations  distinctly  stated  that 
postage  would  be  added  where  small  lots  were  sent  by  mail,  the 
shipping  department  was  extremely  careless  and  few  such  charges 
were  made.  The  auditor  who  discovered  the  laxity  received 
warm  commendation  for  his  vigilance  and  was  requested  to  make 


2  A  pamphlet  entitled  "  Postal  Information,"  is  published  for  free  distribu- 
tion, by  the  Government  Printing  Office,  Washington,  D.  C.  It  contains 
full  information  regarding  rates,  classes  of  mail,  etc. 


568  AUDITING— GENERAL  PRINCIPLES 

the  most  comprehensive  investigation  into  all  the  other  depart- 
ments of  the  business. 

Legal  Expenses  and  "  Graft " 

If  charges  to  legal  expenses  consisted  merely  of  current  bills 
from  attorneys,  no  special  mention  would  be  necessary,  but  the 
account  is  such  an  elastic  one  that  it  requires  special  and  careful 
attention. 

In  some  lines  of  business  secret  commissions  are  paid  to  the 
purchasing  agents  of  customers.  In  spite  of  the  publicity  which 
such  practices  have  received  during  the  last  few  years,  ''graft" 
still  exists  and  no  doubt  will  flourish  for  years  to  come.  If  the 
recipients  are  unusually  sensitive  it  is  customary  to  charge  the 
amounts  paid  to  legal  expenses  or  some  other  account  which 
serves  to  screen  the  true  purpose  of  the  payments.  From  an 
accounting  point  of  view  this  is,  of  course,  highly  objectionable, 
because  it  permits  sales  to  show  what  are  almost  invariably 
excessive  gross  profits  without  the  chance  of  charging  against 
such  sales  one  of  the  important  direct  expenses  connected  there- 
with. Legal  expense  is  not  usually  regarded  as  an  item  of  selling 
costs,  so  that  the  auditor  who  suspects  the  truth  can  hardly  re- 
state the  accounts  to  accord  with  his  suspicion.  The  vouchers 
for  such  payments  are  signed  by  some  responsible  officer  of  the 
corporation  or  a  member  of  the  firm,  so  that  the  honesty  exercised 
in  disposing  of  the  funds  can  hardly  be  questioned. 

Some  years  ago  an  auditor  of  high  standing  discovered  in  the 
audit  of  a  business  that  a  commission  had  been  paid  to  the  super- 
intendent of  the  plant  owned  by  another  client.  He  informed 
the  latter,  but  was  not  profusely  thanked  for  his  information. 
The  other  corporation  learned  of  the  fact,  called  it  a  gross  breach 
of  trust,  and  declined  to  pay  the  auditor's  bill. 

If  an  auditor  feels  that  the  morals  of  his  client  are  to  be  judged 
along  with  the  accounts,  he  should  have  the  courage  of  his  con- 
victions and  so  inform  the  client  before  the  work  is  started.  He 
will  not  then  be  compelled  to  charge  off  his  bill  to  bad  debts. 


THE  DETAILED  AUDIT  5^9 

DEFERRED   CHARGES 

It  has  been  pointed  out  that  an  accurate  income  account  for 
any  period  requires  that  all  transactions  during  the  period  must 
be  included  unless  such  transactions  are  properly  applicable  to  a 
prior  or  subsequent  period.  In  most  cases  the  earnings  which 
actually  accrue  during  the  period  are  easily  stated.  Inventories 
at  the  beginning  and  end  of  the  period  and  depreciation  (which 
are  discussed  elsewhere)  form  the  most  troublesome  factors  of 
uncertainty. 

Allocation  of  Costs  and  Expenses 

Next  in  importance  is  to  ascertain  that  all  other  expenses  and 
costs  which  are  a  proper  charge  against  the  earnings  of  one  period 
appear  in  the  same  period.  Auditors,  in  order  to  be  conservative, 
rarely  object  to  the  charging  off  of  expenses  as  incurred,  even 
though  the  benefit  to  be  derived  from  the  expenditures  must 
necessarily  be  postponed  to  a  later  period.  When  an  advertise- 
ment is  inserted  in  a  magazine  which  appears  after  January  i, 
it  is  obvious  that  no  benefit  can  be  derived  therefrom  prior  to 
January.  If  the  bill  for  the  insertion  is  charged  to  expenses  in 
December,  no  objection  is  usually  made  to  the  practice. 

Nevertheless,  it  is  not  good  accounting  practice  and  if  the 
transactions  are  numerous  or  the  amounts  large  the  auditor  is 
not  justified  in  indorsing  the  practice.  It  obscures  statements 
which  purport  to  exhibit  actual  results.  In  the  case  of  the  ad- 
vertisement cited  above,  the  sales  or  benefit  flowing  therefrom 
may  be  substantial.  If  so,  the  benefit  when  reahzed  is  not 
properly  charged  with  its  actual  cost  so  that  the  profits  of  both 
the  old  and  new  periods  are  incorrect  as  shown  on  the  books. 
By  setting  up  the  cost  when  paid  in  December  as  a  deferred 
expense,  carrying  it  on  the  balance  sheet  temporarily  as  an  asset, 
and  charging  it  off  as  an  expense  in  January,  the  equilibrium  of 
the  accounts  is  maintained  and  statements  made  from  the  books 
are  correct. 


570  AUDITING— GENERAL  PRINCIPLES 

In  this  connection  it  should  be  borne  in  mind  that  the  term 
"good  accounting  practice"  is  not  wholly  a  technical  expression; 
it  is  an  inclusive  term  and  comprehends  moral  as  well  as  business 
practices.  A  corporation  may  start  with  a  cash-paid-in  capital 
of  $1,000,000.  Pursuant  to  a  well-defined  plan  it  may  expend 
most  of  the  capital  in  development  expenses  during  the  first  year 
or  two.  At  the  end  of  the  third  year  its  balance  sheet  may  show 
a  large  deficit  or  deferred  charges,  depending  on  the  method  of 
bookkeeping.  If  a  deficit  is  shown,  stockholders  will  be  dis- 
couraged and  sell  out  their  stock  at  a  loss.  The  favored  few  who 
realize  that  the  balance  sheet  does  not  correctly  state  the  condi- 
tion of  the  corporation  will  buy  this  stock  at  much  less  than  it  is 
actually  worth.  During  the  fourth  year  large  profits  are  shown 
to  have  been  earned,  because  there  are  no  deferred  expenses  to  be 
charged  off.  The  stock  goes  up  and  those  who  were  fortunate 
enough  to  know  that  the  books  misrepresented  actual  conditions 
will  reap  the  benefit.  The  balance  sheet  showing  the  large  de- 
ficit and  the  later  balance  showing  the  increased  profit  were 
both  false. 

The  foregoing  comments  must  be  restricted  to  expenditures 
which  clearly  aid  or  which  are  intended  to  aid  subsequent  periods. 
From  the  standpoint  of  good  accounting  practice,  there  is  no 
option  as  to  how  the  items  shall  be  charged.  The  fimction  of 
accounting  is  to  portray  in  a  scientific  manner  the  financial  condi- 
tion of  a  business.  If  expenses  are  incurred  in  a  single  year  or 
during  a  few  years,  and  if  those  expenses  are  incurred  wholly 
for  the  purpose  of  increasing  profits  in  future  years,  such  expenses 
are  clearly  in  the  nature  of  an  investment.  If  they  are  charged 
off  as  expenses  in  the  year  they  are  incurred,  the  current  book 
profits  are  smaller  and  the  subsequent  book  profits  are  greater 
than  is  actually  the  case,  and  the  real  purpose  of  keeping  the 
books  is  defeated;  the  books  do  not  present  the  real  condition  of 
the  business.  Charging  such  expenditures  to  periods  which  can- 
not realize  the  benefits  is  bad  accounting  practice.  From  the 
point  of  view  of  expediency,  or  to  be  ultra-conservative,  auditors 


THE  DETAILED  AUDIT  57^ 

frequently  approve  charging  off  immediately  to  operation  items 
of  deferred  charges  which  are  properly  classed  as  capital  expendi- 
tures. At  least  this  was  frequently  done  when  tax  rates  were 
low.  Probably  the  only  regret  flowing  from  ultra-conservative 
charging  off  or  writing  down  plant  values  to  $i  has  been  the 
trouble  incident  to  restoring  all  capital  expenditures  to  the  books 
for  invested  capital  purposes. 

The  practice  of  charging  off  such  expenses  immediately  has 
been  changed  to  no  small  extent  by  the  passage  of  laws  levying 
high  income  tax  rates.  A  practice  which  might  be  passed  over 
as  conservative  under  a  i  per  cent  tax  law,  might  easily  result  in 
disaster  under  an  80  per  cent  law.  Failure  to  charge  against 
the  years  19 18  and  191 9  the  expenses  which  belong  to  those  years 
might  result  in  a  tax  of  over  100  per  cent  of  the  actual  net  income. 

This  fact  is  illustrated  by  a  case  coming  to  the  author's  atten- 
tion, the  facts  of  which  were  as  follows:  A  corporation  was 
organized  in  19 14  for  the  purpose  of  engaging  in  a  business  the 
very  nature  of  which  required  that  an  extensive  campaign  be 
carried  on  during  the  first  few  years  for  advertising  purposes  and 
to  secure  contracts  running  for  terms  of  several  years.  This 
campaign  was  not  wholly  for  the  purpose  of  building  up  good- 
will. The  business  had  been  carried  on  for  a  number  of  years  by 
a  department  of  a  nationally  known  corporation.  The  campaign 
was  more  in  the  nature  of  development  work — expanding  the  busi- 
ness to  take  in  other  industries  than  the  one  which  had  originally 
utilized  it. 

During  the  first  three  years  of  the  corporation's  existence, 
almost  $750,000  was  expended  in  this  development  work.  Dur- 
ing these  years  the  profits  averaged  $100,000,  the  development 
work  being  charged  to  expense.  In  1917,  1918,  and  191 9  there 
were  no  development  expenses  and  the  average  profits  as  shown 
by  the  books  increased  to  over  $250,000.  In  191 9  alone,  the  book 
profits  were  over  $400,000.  Obviously  these  large  profits  were 
the  result  of  the  contracts  which  had  been  entered  into  at  great 
expense  during  the  first  three  years,  and  that  expense  should 


572  AUDITING— GENERAL  PRINCIPLES 

have  been  charged  off  in  the  years  which  reaped  the  benefit  of 
those  contracts.  As  a  result  of  not  doing  so,  the  corporation 
was  put  to  considerable  embarrassment.  The  small  book  profits 
of  the  first  few  years — made  smaller  than  they  actually  were  by 
charging  development  expenses  to  those  years — were  taxed  at  the 
rates  of  i  and  2  per  cent.  The  profits  of  the  years  191 7, 1918,  and 
1 91 9 — appearing  on  the  books  as  greater  than  they  actually  were 
because  those  years  did  not  bear  any  of  the  expenses  which  made 
those  profits  possible — were  taxed  at  the  higher  rates  obtaining 
in  the  excess  profits  schedules  of  the  Revenue  Acts  of  191 7  and 
1918. 

The  author  looks  forward  to  the  time  when  invested  capital 
in  its  technical  sense  will  be  no  longer  a  factor  in  accounting  and 
when  good  accounting  practice  can  again  be  disregarded  without 
penalty.  The  foregoing  statement  applies  only  to  such  situations 
as  afford  good  reasons  for  conservatism  and  where  the  special 
treatment  of  the  items  is  clearly  set  forth  so  that  no  one  is 
deceived. 

All  payments  for  insurance,  bank  discount,  rent,  taxes,  dues, 
subscriptions,  and  similar  items  should  be  scrutinized  in  order  to 
determine  the  proportion,  if  any,  which  applies  to  a  subsequent 
period  and  thus  constitutes  an  asset,  when  the  books  are  closed, 
in  the  form  of  a  deferred  charge  to  the  future  operations  of  the 
business.  To  save  time,  the  auditor  may  request  one  of  the 
client's  clerks  or  the  insurance  broker  to  calculate  the  prepaid 
items,  in  all  cases  testing  the  accuracy  of  their  work. 

Extraordinary  expenditures,  such  as  repairs  and  renewals 
incident  to  accidents  or  storms,  are  sometimes  capitalized  at  the 
time  they  are  incurred,  with  the  expressed  intention  of  spreading 
the  loss  over  several  years.  The  same  situation  arises  where 
accident  insurance  is  not  carried.  A  certain  percentage  of  the 
gross  receipts  is  set  aside  in  a  reserve  account  to  pay  losses,  the 
payments  being  in  excess  of  the  reserve.  Quite  frequently  the 
debit  balances  so  created  are  carried  forward  as  an  asset  until 
subsequent  accruals  wipe  out  the  deficit. 


THE  DETAILED  AUDIT  573 

This  practice  is  not  sound,  because  in  the  last  analysis  it 
simply  results  in  setting  up  on  the  balance  sheet  accounts  which 
are  in  no  sense  of  the  word  assets.  If  the  word  ''assets"  means 
anything  at  all,  there  is  no  justification  for  including  in  it 
items  of  maintenance,  expended  because  of  necessity,  which 
do  not  tend  to  improve  the  physical  or  financial  position  of  the 
enterprise. 

Perhaps  these  charges,  if  incorporated  among  the  costs  and 
expenses  of  a  current  period,  tend  to  hide  the  normal  operations; 
but  if  the  unusual  item  is  clearly  set  forth,  this  procedure  is  pre- 
ferable to  making  direct  charges  to  surplus.  It  may  be  hard  to 
resist  the  temptation  to  capitalize  these  items,  but  the  practice 
is  to  be  condemned.  It  may  not  sound  well  or  look  well,  but  it 
has  the  advantage  of  portraying  the  actual  state  of  affairs.  This 
is  not  the  case  when  an  attempt  is  made  to  call  an  expense  account 
an  asset.  Directors  who  realize  their  personal  responsibility 
for  dividends  paid  out  of  capital  will  not  vote  for  a  distribution  of 
earnings  which  does  not  take  into  account  expenses  actually 
incurred. 

Bond  Discount. — If  discount  on  bonds  is  carried  as  a  deferred 
charge  to  operations,  the  auditor  should  verify  the  amortization 
calculations.  If  this  provision  is  not  in  order,  an  adjustment 
should  be  made  before  the  balance  sheet  is  certified  to. 

One  of  the  most  interesting  parts  of  the  opinion  of  the  Superior 
Court  of  Pennsylvania  in  revising  the  order  of  the  Pennsylvania 
Public  Service  Commission  in  the  Ben  Avon  Borough — Ohio 
Valley  Water  Co.  case,  ^  dealt  with  the  treatment  of  bond  discount 
as  a  capital  charge.  The  court  found  that  bond  discount  to  the  ex- 
tent of  7  1/2  per  cent  of  the  reproduction  cost  of  the  property  was 
a  fair  amount  to  be  included  in  capital  value.    The  court  said: 

Concerning  the  item  of  brokerage,  the  courts  and  commissions  of 
other  states  have  held  that  discounts  on  securities  should  be  allowed;  as 
utilities,  like  other  companies,  are  not  able  to  make  their  financial  arrange- 


3  68  Pa.  Superior  Ct.  561,  591. 


574  AUDITING— GENERAL  PRINCIPLES 

ments  without  allowing  such  discount.  The  difference  between  the 
amounts  derived  from  the  sale  of  its  bonds  and  the  amount  which  the 
company  must  eventually  pay  on  the  bonds  has  been  regarded  as  a  part  of 
capital  charge  for  construction.  While  corporations  should  not  be  per- 
mitted to  capitalize  their  lack  of  credit,  still,  where  bonds  are  sold  at  a 
reasonable  discount  and  bear  a  fair  rate  of  interest,  such  discount  should 
be  allowed.  What  is  a  fair  discount  depends  upon  the  condition  of  the 
money  market  and  the  ability  of  the  organizers  to  attract  capital  to  the 
project.  It  is  a  well-known  fact  that  the  great  majority  of  companies  are 
started  without  all  the  available  cash  necessary  to  complete  the  undertak- 
ing. This  country  would  not  have  reached  its  great  stage  of  industrial 
development  if  it  had  been  the  rule  that  all  capital  must  be  procured  in 
advance  by  fully-paid  stock  subscriptions.  If  a  legal  rate  of  return  was 
all  that  was  offered,  the  investor  could  very  well  answer  that  without  risk 
and,  with  a  safe  margin  of  value,  money  could  be  loaned  on  lands  and 
buildings  at  this  rate  of  return.  When  solicited  to  invest  in  a  new  pro- 
ject, with  the  uncertainty  of  success  before  him,  the  investor  demands  a 
return  commensurate  with  the  risk  involved,  and  that  must  be  something 
more  than  a  legal  rate  investment.  If  the  venture  is  a  failure,  the  investor 
is  compelled  to  take  his  loss  without  any  hope  of  recoupment;  but  it  is 
equally  unfair  to  require  him  to  suffer  all  the  loss  if  the  enterprise  fails, 
and  to  deprive  him  of  the  chance  of  additional  gain  if  the  venture  is  a 
successful  one. 

Doubtful  Deferred  Charges 

In  addition  to  the  expenditures  heretofore  discussed  which 
clearly  benefit  subsequent  periods,  there  are  expenditures  the 
benefits  from  which  are  doubtful.  When  there  is  doubt  as  to 
such  benefits,  good  accounting  practice  cannot  prescribe  specific 
treatment.  The  conservative  method  is  to  immediately  charge 
off  all  doubtful  items,  but  if  there  is  a  question  as  to  what  periods 
will  receive  the  benefits  and  if  the  amount  involved  is  substantial, 
good  accounting  practice  leaves  to  the  accountant  the  option  of 
charging  off  such  expenditures  over  a  certain  period  of  years  or  of 
charging  them  off  currently. 

More  than  one  enterprise  has  been  wrecked  by  the  failure  to 
look  preliminary  or  establishment  expenses  squarely  in  the  face. 
The  temptation  to  state  the  current  operations  in  such  a  way  as  to 


THE  DETAILED  AUDIT  575 

show  a  profit  was  too  strong ;  so  those  concerns  have  gone  along 
from  year  to  year,  the  burden  increasing  instead  of  diminishing, 
until  the  inevitable  day  of  reckoning,  when  it  was  realized  than 
liabilities  cannot  be  liquidated  with  capitalized  expenses. 

The  recent  report  of  an  automobile  business  stated  that  the 
auditors  had  insisted  on  charging  ofif  all  of  the  expenses  of  estab- 
lishing branches  which  previously  had  been  carried  as  an  asset. 
The  monthly  reports  had  shown  big  profits,  which  had  been 
largely  paid  out  in  dividends,  with  the  result  that  the  working 
capital  had  been  reduced  to  an  amount  below  the  safety  line.  If 
auditors  with  the  courage  of  their  convictions  had  been  consulted 
earlier,  the  company's  credit  would  probably  not  have  been  im- 
paired to  so  great  an  extent. 

Experimental  and  Development  Expenditures. — The 
results  of  experimental  and  development  work  cannot  be  fore- 
seen and,  since  subsequent  benefits  are  doubtful,  the  treatment 
is  to  some  extent  optional;  but  under  certain  conditions  good 
accounting  practice  requires  that  such  expenditures  be  capitalized. 
There  are  three  methods  of  handling  such  items:  (i)  capitalize 
them;  (2)  amortize  them  over  a  limited  period  or  over  a  definite 
output  of  product;  (3)  write  them  off  immediately. 

1.  When  expenditures  are  extraordinary  and  are  made  with  a 
specific  purpose,  such  as  a  reduction  in  costs  or  an  increase  in 
production,  it  is  improper  to  charge  the  cost  of  the  work  to  a 
period  which  cannot  benefit  from  it.  Improvements  in  patents 
and  in  processes  which  have  a  continuing  value  should  be  capi- 
talized and  written  off  or  else  carried  permanently  depending  on 
the  circumstances. 

2.  When  the  value  or  benefit  of  the  expenditures  can  be  allo- 
cated to  a  definite  period  or  to  a  definite  output,  the  cost  should 
be  spread  over  such  period  or  such  output.  For  instance,  the  cost 
of  an  improved  process  for  refining  ore  or  mining  coal  should  be 
spread  over  the  life  of  the  mines  benefiting  from  the  process. 

3.  When  experimental  or  development  work  is  carried  on 


576  AUDITING— GENERAL  PRINCIPLES 

with  more  or  less  continuity  and  as  a  settled  policy,  it  is  proper  to 
write  off  such  expenditures  immediately. 

Organization  Expenses 

Formerly  if  the  expenses  incurred  in  the  organization  of  the 
company  (such  as  incorporation  fees,  legal,  engineering,  and  other 
expenses,  engraving  bonds  and  stock  certificates,  transfer  fees 
and  stamps,  etc.)  were  more  than  could  fairly  be  charged  into 
current  expenses,  it  was  considered  permissible  to  spread  such 
charges  over  a  term  of  years,  preferably  three,  but  not  more  than 
five.  Sentiment  is  changing  as  to  the  wisdom  of  spreading  these 
expenses  over  more  than  three  years.  The  best  practice  is  to 
charge  off  immediately  everything  which  has  no  tangible  or  re- 
sidual value.  The  benefit  from  such  items  cannot  be  compared  to 
advertising  and  exploitation  expenses.  It  is  a  fallacy  to  assume 
that  stock  certificates,  incorporation  expenses,  etc.,  have  any 
of  the  attributes  of  an  asset;  and  so  the  sooner  the  cost  appears 
in  the  expense  account,  the  better. 

The  old  theory  of  deferring  part  of  the  charge  to  income 
was  sound  enough,  but  the  rule  has  been  abused;  and  so  we 
now  find  apportionments  over  five  years  or  longer.  In  some  cases 
all  organization  expenses,  using  the  term  in  its  broadest  sense,  are 
permanently  capitalized.  The  author  advocates  charging  off  all 
such  expenses  as  they  are  incurred. 

But  it  should  be  ascertained  whether  or  not  the  promoters  (if 
the  enterprise  was  "promoted")  agreed  to  pay  any  part  of  these 
expenses.  This  is  a  matter  of  increasing  importance,  because  a 
number  of  corporations  are  being  organized  where  this  obligation 
is  assumed  by  the  organizers. 

Expenses  to  Secure  Future  Business. — Other  items,  such 
as  advertising  and  exploitation  expenditures  which  are  intended 
to  produce  future  business,  may  not  appear  to  be  a  proper  charge 
against  income  whxh  could  hardly  have  received  the  benefit  of 
such  payments.    An  auditor  may  pass  the  carrying  forward  of 


THE  DETAILED  AUDIT  577 

any  legitimate  expenditure  which  has  been  incurred  solely  for  the 
benefit  of  future  business,  provided  that  in  his  judgment  the 
setting  up  of  the  deferred  charge,  and  its  consequent  inclusion 
as  an  asset,  is  justified  by  its  probable  value  to  the  future  business. 

But  it  is  not  enough  that  the  expenditure  has  been  made.  For 
instance,  a  large  number  of  circular  letters  calling  attention  to  a 
special  sale  in  January  may  be  sent  out  in  December.  If  the 
auditor  commences  work  in  February  and  finds  that  the  campaign 
was  a  total  failure,  it  would  be  rather  misleading  for  him  to  certify 
to  the  accuracy  of  a  balance  sheet  as  of  December  31  showing  the 
entire  expenditure  as  an  asset. 

An  auditor  should  be  willing  to  back  up  his  opinion  with  his 
certificate.  If  in  his  opinion  expenditures  of  this  nature  are 
actually  deferred  assets,  he  should  so  certify.  It  should,  however, 
be  noted  that  the  most  successful  concerns  carry  on  selling  cam- 
paigns all  the  time,  and  there  must  be  some  limit  to  the  postpone- 
ment of  the  actual  charges  to  current  operating. 

If  the  business  is  not  successful  there  will  be  no  future  profits 
to  which  the  deferred  items  can  be  charged.  Therefore,  the 
auditor  should  use  every  argument  he  can  muster  to  induce  his 
client  to  absorb  these  expenses  as  soon  as  possible,  and  never 
to  carry  them  forward  unless  it  is  improper  to  include  them  among 
the  current  expenses. 

VOL.  I — 37 


CHAPTER  XXVI 

THE  DETAILED  AUDIT  (Concluded) 

In  addition  to  the  verification  of  all  items  of  possible  revenue 
and  expenditure,  the  program  of  a  detailed  audit  is  not  complete 
without  a  more  exhaustive  investigation  into  certain  phases  of 
the  accounts,  and  the  consideration  of  trial  balances  as  such  and 
all  accounts  therein  to  determine  which  represent  proper  real  and 
nominal  accounts  and  which,  if  any,  are  merely  ledger  accounts 
which  require  analysis  and  restatement  in  order  to  make  possible 
any  intelligent  use  thereof. 

THE  TRIAL  BALANCE 

One  of  the  most  important  matters  in  any  audit  is  the  verifica- 
tion of  the  trial  balance.  By  this  is  not  meant  the  routine  check- 
ing of  the  ledger  footings  and  extraction  of  the  balance  merely  to 
test  its  arithmetical  accuracy,  but  that  careful  examination  or 
study  of  it  which  throws  light  on  the  entire  and  detailed  working 
of  the  whole  system.  Every  ledger  caption  should  mean  some- 
thing. After  some  experience,  an  auditor,  by  simply  looking  at 
the  various  accounts  scheduled  on  the  trial  balance,  is  able  to 
discuss  the  whole  system,  and  without  further  data  to  suggest 
improvements  therein.  Of  course,  no  sane  practitioner  commits 
himself  after  such  a  cursory  glance,  but  he  gains  sufficient  insight 
into  the  affairs  of  his  client  to  suggest  the  next  and  succeeding 
steps  in  the  audit.  He  must  not  spend  too  much  time  on  trifling 
errors  in  a  trial  balance,  but  should  take  enough  time  to  satisfy 
himself  that  the  trial  balance  honestly  represents  the  face  of  the 
ledgers  and  that  it  may  be  relied  on  as  a  basis  for  a  report  or 
balance  sheet. 

The  auditor  should  secure  a  copy  of  the  last  trial  balance  at 

578 


THE  DETAILED  AUDIT  579 

the  earliest  possible  moment.  Usually,  if  he  asks  for  it  at  the 
commencement  of  an  audit,  it  will  be  copied  for  him  by  an  office 
clerk.  He  need  not  ask  for  the  customers'  balances  in  detail, 
since  he  will  wish  to  compile  these  himself,  as  explained  hereafter. 
As  to  the  other  accounts,  however,  the  trial  balance  is  of  great 
importance.  Subsequent  analyses  of  accounts  will  lead  up  to  the 
trial  balance,  and  any  alteration  of  figures  in  the  ledger  will 
probably  be  disclosed  thereby. 

If  the  trial  balance  is  not  correct,  it  is  no  part  of  an  auditor's 
duties  to  locate  the  error  or  errors  therein.  He  should  insist  that 
the  client's  staff  secure  an  exact  balance;  if  this  is  impracticable, 
the  matter  should  be  referred  to  the  client  and  an  understanding 
reached  as  to  further  procedure. 

The  best  plan  is  for  the  audit  to  proceed  as  if  no  difference 
exists.  The  various  tests  suggested  should  be  made,  but  no  other 
steps  taken,  unless  numerous  errors  are  discovered,  in  which  case 
permission  should  be  secured  from  the  client  to  verify  all  the  work 
and  secure  a  correct  balance.  If  the  errors  are  few  in  number 
and  the  accounts  are  reasonably  correct,  the  auditor  should  not 
attempt  to  hunt  for  clerical  errors.  He  can  better  postpone  the 
audit  until  they  are  located,  even  if  an  additional  clerk  is  required. 
Anyone  who  spends  his  time  in  such  work  is  not,  and  is  not  de- 
veloping into,  a  professional  auditor.  Such  elementary  book- 
keeping work  should  be  left  to  clerks. 

Outstanding  Accounts 

A  schedule  of  accounts  receivable  should  be  compiled  to 
supplement  the  trial  balance.  It  is  a  waste  of  time  to  prepare  or 
verify  a  trial  balance  and  subsequently  duplicate  the  larger  part 
of  such  work  in  the  verification  of  customers'  balances. 

The  balance  due  from  each  customer  should  represent  specific 
invoices  unpaid,  or  else  it  should  be  clear  that  the  debtor  is 
making  partial  payments.  If  the  credits  indicate  that  the  latter 
is  not  the  case,  even  though  the  balance  due  cannot  be  identified 
with  the  most  recent  invoices,  then  it  is  apparent  that  a  discrep- 


58o  AUDITING— GENERAL  PRINCIPLES 

ancy  exists  which  requires  explanation.  In  all  such  cases  the 
auditor  should  require  one  of  the  office  staff  to  show  the  composi- 
tion of  the  balance.  It  may  develop  that,  in  order  to  furnish  this 
information,  the  entire  account  must  be  analyzed,  but  this,  of 
course,  is  the  best  possible  reason  for  insistence  on  the  part  of  the 
auditor. 

Income  from  sales  cannot  he  completely  verified  until  all  debits 
to  customers  are  ascertained  to  he  collectihle;  charges  known  to  be 
uncollectible,  but  remaining  open  in  the  accounts  of  solvent  debt- 
ors, may  be  difficult  to  locate,  but  are  none  the  less  important. 

If  the  balances  used  in  the  final  trial  balances  are  not  brought 
down,  they  should  at  least  be  noted  on  the  ledger  pages.  Prefer- 
ably this  should  be  done  by  the  office  staff,  but,  if  necessary,  the 
auditor  should  do  it  himself.  When  credit  balances  appear  on 
customers'  accounts,  the  total  of  such  balances  should  be  included 
among  the  liabilities  and  the  total  debit  balances  should  be  set 
forth  as  accounts  receivable  instead  of  including  the  net  balances 
only  as  assets. 

Examine  accounts  written  off  during  previous  years  and  see 
whether  any  effort  is  being  made  to  collect  from  those  which  are 
not  absolutely  worthless. 

Bad  or  Doubtful  Accounts 

The  schedule  just  referred  to,  in  addition  to  showing  that  the 
balances  due  from  solvent  debtors  are  composed  of  collectible 
items,  should  indicate  each  account  that  is  overdue,  so  that  in- 
quiry can  be  made  about  such  items  to  determine  the  amount 
required  to  be  reserved.  In  addition,  an  amount  should  be  re- 
served for  the  current  items  based  on  past  experience.  The 
deduction  of  the  sum  of  these  two  reserves  should  bring  the 
aggregate  due  from  trade  debtors  to  an  estimate  of  the  amoxmt 
which  will  be  realized  in  cash. 

It  is  not  always  desirable  to  close  a  doubtful  account  to 
income,  and  it  is  never  desirable  to  carry  an  account  long  over- 
due among  the  current  accounts.    The  best  practice,  therefore,  is 


THE  DETAILED  AUDIT  58 1 

to  transfer  the  account  (or  the  sheet,  if  the  ledger  is  in  loose-leaf 
form)  to  a  doubtful  accounts  ledger,  at  the  same  time  creating  a 
reserve  therefor.  The  balances  in  this  supplemental  ledger  will 
not  be  lost  sight  of,  since  they  form  part  of  the  trial  balance. 

As  soon  as  an  account  is  known  to  be  irretrievably  bad,  it 
should  be  written  off  entirely.  In  the  meantime  a  record  of  the 
progress  of  collection,  such  as  commencement  of  suit,  etc.,  should 
be  noted  on  the  account. 

Provision  for  bad  accounts  in  the  form  of  a  reserve  should  be 
made  each  month,  based  on  a  percentage  of  the  total  sales.  This 
fixes  in  the  minds  of  all  concerned  the  fact  that  losses  may  be 
expected,  and  stimulates  the  credit  and  collection  departments  to 
keep  down  the  losses  and  "make  a  profit  on  the  reserve.''  If  this 
course  is  not  followed,  the  auditor  must  make  the  reserve  large 
enough  to  cover  the  losses  which  his  experience  teaches  will  be 
incurred. 

In  this  respect  managers  and  others  sometimes  mislead  the  au- 
ditor because  they  do  not  admit  the  full  amount  of  the  bad  ac- 
counts. After  some  years  of  experience  an  auditor  finds  that  his 
opinion  on  this  point  is  better  than  anyone  else's  and  he  should 
use  his  own  judgment  in  stating  the  probable  losses.  This  ap- 
plies especially  where  the  business  is  comparatively  old  and  actual 
losses  for  a  series  of  years  can  be  ascertained. 

ASSET  AND   LIABILITY  ITEMS 

From  the  point  of  view  of  cUents'  relations  to  their  employees, 
the  audit  of  income  and  expenses  is  more  important  than  the 
audit  of  the  balance  sheet;  but  the  accuracy  or  inaccuracy  of  the 
balance  sheet  affects  proprietors,  whether  partners  or  stock- 
holders, as  well  as  the  public  through  its  representatives,  the 
bankers,  creditors  and  prospective  investors.  It  is  also  of  im- 
portance as  a  basis  of  transfer  from  one  partner  to  another. 

The  detailed  audit  naturally  includes  a  verification  of  the 
assets  and  HabiUties,  and,  in  order  to  avoid  repetition,  the  chap- 


582  AUDITING— GENERAL  PRINCIPLES 

ters  on  balance  sheet  audits '  should  be  referred  to  as  indicating  a 
part  of  the  program  of  a  detailed  audit.  Some  balance  sheet 
items  are  more  fully  covered  in  a  detailed  audit  than  in  a  balance 
sheet  audit.    They  will  now  be  discussed. 

Notes  Receivable 

The  record  of  notes  received  should  be  examined,  and  if  com- 
paratively few  notes  have  been  received,  the  disposition  of  each 
note  should  be  followed  from  the  account  to  which  credited  until 
collected  or  returned  impaid.  If  a  large  niunber  of  notes  have 
been  received,  the  auditor  should  test  the  accuracy  of  the  record 
by  selecting  a  few  months  at  random  out  of  the  year  and  verifying 
in  detail  the  transactions  appearing  in  those  months. 

Notes  Receivable  Protested 

See  that  protested  notes  are  charged  back  to  the  account  of 
debtor,  and  that  a  subsequent  attempt  is  made  to  collect.  The 
protested  note  should  be  submitted  as  a  voucher  or  otherwise 
accounted  for  in  all  cases  where  the  item  is  still  open.  It  is 
possible  for  a  dishonest  cashier  to  charge  back  as  unpaid,  items 
actually  collected,  and  subsequently  write  off  the  account  to  bad 
debts;  but  in  such  a  case,  as  no  voucher  can  be  produced,  the 
fraud  is  disclosed.  It  is  a  small  matter,  but  the  auditor  should 
ascertain  whether  or  not  all  protest  fees  and  accrued  interest,  as 
well  as  the  face  of  the  notes,  are  charged  to  debtors.  In  many 
cases  collection  can  be  made  subsequently,  so  that  the  omission 
to  charge  all  proper  items  direct  to  debtors'  accounts  means  the 
loss  of  such  items. 

Inventories 

In  a  detailed  audit  this  item  in  the  balance  sheet  should  be 
examined  first  if  there  are  collateral  indications  that  the  business 
has  been  profitable,  even  though  the  books  show  a  loss.  Inven- 
tories are  frequently  taken  hurriedly,  materials  in  transit  are  often 

^  Page  7 1  et  seq. 


THE  DETAILED  AUDIT  583 

omitted,  or  included  when  the  bills  therefor  have  not  been  en- 
tered. An  inventory  at  the  beginning  of  a  period  may  be  over- 
valued, and  at  the  end  midervalued,  and  numerous  other  causes 
may  be  cited  to  suggest  errors  which,  if  not  detected,  result  in 
misleading  income  statements.  In  a  case  of  this  nature  an  auditor 
finds  the  inventories  a  most  fruitful  source  of  error. 

Here  also  an  auditor  must  use  good  judgment  in  passing 
values,  for  each  increase  or  decrease  in  an  inventory  affects  the 
income  account  correspondingly.  It  is  about  as  bad, to  pass 
values  which  are  understated  as  to  pass  values  which  are  over- 
stated, where  the  result  may  be  used  for  ulterior  purposes.  The 
most  flagrant  cases,  however,  are  overvaluations.  With  these  an 
auditor  must  deal  without  fear  or  favor. 

Premiums  and  Discounts  on  Bonds  to  Be  Amortized 

When  bonds  are  sold  at  a  premiimi,  the  amount  received  in 
excess  of  the  par  value  represents  the  equivalent  of  interest  col- 
lected in  advance,  and  must  be  held  in  reserve  and  distributed 
over  the  years  to  which  it  applies  as  a  reduction  in  bond  interest 
account.  For  instance,  a  corporation  may  sell  its  5  per  cent  ten- 
year  bonds  at  105,  indicating  that  its  credit  is  rated  on  a  basis  of 
about  4  1/2  per  cent;  that  is,  if  a  4  1/2  per  cent  bond  had  been 
issued,  the  corporation  should  have  realized  about  par.  Therefore, 
the  bond  interest,  when  paid,  is  subject  to  a  deduction  of  one-half 
of  I  per  cent  annually.  The  excess  received  at  the  time  of  sale 
should  not  be  applied  to  income  or  to  surplus,  but,  as  stated  above, 
must  be  carried  as  a  deferred  credit  and  reduced  annually. 

Likewise,  when  bonds  are  sold  at  a  discount  it  is  because  the 
rate  of  interest  the  bonds  bear  is  less  than  the  effective  rate  at 
which  the  corporation's  credit  is  rated.  For  instance,  if  5  per 
cent  ten-year  bonds  are  sold  at  90,  this  means  that  the  corpora- 
tion's borrowing  strength  is  rated  at  about  6  per  cent,  and,  in 
order  to  reflect  the  actual  rate  each  year  as  interest  is  paid,  it  is 
necessary  to  carry  the  discount  as  a  deferred  charge  among  the 
assets  and  write  off  to  interest  account  i  per  cent  annually.   This, 


584  AUDITING— GENERAL  PRINCIPLES 

added  to  the  amount  paid  in  cash,  adjusts  the  interest  account  to 
the  proper  cost. 

A  clear  exposition  of  the  subject  of  amortization,  with  corre- 
sponding tables  for  annuities,  present  worth,  sinking  funds,  etc., 
can  be  found  in  Accountancy  of  Investment  by  Sprague-Perrine. 

Premiums  on  Capital  Stock 

With  respect  to  premiums  received  on  capital  stock,  the 
principle  is  different.  There  is  no  liability  on  account  thereof,  and 
no  distribution  to  the  income  of  future  years. 

The  amount  received  is  clearly  a  capital  receipt  and  is  not 
available  as  a  fund  out  of  which  to  pay  dividends;  that  is,  from  an 
accounting  point  of  view.  There  may  be  no  legal  obstacle  in  the 
way  of  crediting  the  premiums  to  surplus,  and  paying  out  the 
entire  surplus  as  dividends,  but  in  effect  a  board  of  directors 
might  as  well  attempt  to  pay  out  the  remaining  portion  of  the 
amount  received  for  stock.  Let  us  suppose  that  stock  is  issued  at 
$110  per  share,  $100  being  credited  to  capital  stock,  and  $10  to 
surplus.  If  the  latter  amount  is  distributable,  why  not  $10  more, 
leaving  $90  to  be  credited  to  capital?  The  answer  would  probably 
be  made  that  the  law  does  not  permit  capital  stock  to  be  issued  at 
a  discount,  but  since  property  of  all  kinds  may  be  turned  in  as 
payment  for  stock,  the  theory  of  stock  being  issued  for  actual 
value  is  a  dead  letter. 

Premiums  received  on  capital  stock  should  be  credited  to  an 
account  so  entitled  or  to  capital  surplus,  and  should  not  be  ab- 
sorbed in  the  regular  surplus  account. 

Premium  on  Redeemable  Preferred  Stock 

When  preferred  stock  is  issued  with  a  provision  that  it  is 
redeemable  after  five  years  at  no,  or  any  other  figure,  the 
premium  paid  at  redemption  may  be  considered  an  extra  dividend. 

It  must  be  remembered  that  the  provision  to  redeem  the  stock 
at  a  premium  cannot  be  made  mandatory.  The  premium  is  a 
charge  against  profits  in  any  event,  and  cannot  be  paid  unless 


THE  DETAILED  AUDIT  5^5 

there  are  sufficient  profits  earned  out  of  which  to  pay  it.  A 
promise  to  redeem  at  a  premium  is  not  binding  because  of  this 
unavoidable  condition. 

Branch  Accounts 

The  extent  of  the  examination  of  branch  accounts  should 
depend  on  the  system  of  accounts  employed.  Where  local  collec- 
tions are  made,  the  accounts  receivable  require  the  same  attention 
as  described  on  page  579;  where  shipments  are  reported  to  the 
head  office,  and  collections  are  not  made  locally,  there  is  still  the 
necessity  of  testing  the  delivery  records  to  ascertain  that  all  have 
been  reported,  and  that  cash  sales,  if  any,  have  been  duly  ac- 
counted for.  At  the  same  time  the  stock  accounts  require  atten- 
tion, both  from  the  point  of  view  of  theft  or  loss  and  overvaluation. 

Nearly  all  branch  managers  have  an  interest  in  the  profits 
derived  from  their  own  territory,  and  in  consequence  nearly  all 
branch  managers  place  the  highest  possible  valuation  on  their 
stock-in-trade.  It  may  seem  difficult  to  manipulate  the  stock 
record  valuations  where  prices  are  fixed  at  the  head  office,  but  op- 
portunities usually  arise  in  connection  with  shopworn  or  obsolete 
stock,  etc.,  and  in  some  cases  quantities  are  deliberately  overstated. 

Local  expenses  and  purchases  are  usually  reported  to  the 
head  office  in  detail,  so  that  outstanding  liabilities  should  be  com- 
paratively easy  to  verify.  If  paid  locally,  the  usual  precautions 
must  be  taken  to  ascertain  that  no  omissions  are  made.  ^ 

In  some  cases  where  time  does  not  permit  an  auditor  to  visit 
all  branches  personally,  local  auditors  can  be  employed  to  ad- 
vantage. Uniform  instructions  should  be  sent  out  and  adhered  to 
strictly,  so  that  the  auditor  in  charge  can  feel  safe  in  using  the 
figures  so  verified. 

Capital  Expenditure 

Throughout  the  audit  of  expenditure  the  distinction  between 
capital  and  income  must  be  borne  in  mind.     It  is  sometimes 

2  See  page  538  et  seg. 


586  AUDITING— GENERAL  PRINCIPLES 

believed  tiiat  so  long  as  expenditure  for  capital  outlay,  as  well  as 
for  current  maintenance,  is  charged  to  income  and  not  capitalized, 
no  fault  can  be  found  with  such  a  conservative  course,  but  that 
the  reverse  of  this  practice  cannot  be  justified  under  any  circum- 
stances. Theoretically  this  position  is  wrong,  the  proper  rule 
being  to  ascertain  the  correct  application  of  each  payment  and 
to  charge  the  account  to  which  the  item  belongs.  Practically, 
much  can  be  said  in  support  of  what  is  known  as  the  conservative 
method. 

Maintenance  versus  Construction. — The  great  difficulty 
in  ascertaining  the  exact  effect  of  alterations,  betterments,  and 
new  construction,  and  the  prevailing  tendency  of  managers  and 
others  to  emphasize  the  propriety  of  capitalizing  the  payments, 
inevitably  educate  accountants  and  business  men  who  do  not 
want  to  deceive  themselves,  to  the  determination  to  charge  to 
maintenance  every  item  about  which  there  is  the  slightest  doubt 
In  other  words,  a  practice  which  is  objectionable  in  theory  be- 
comes a  virtue  in  practice,  and  a  substantial  reason  therefor  is 
that  the  business  always  gains  thereby  and  never  loses. 

The  audit  of  capital  expenditure  is  rarely  satisfactory  when 
made  by  items,  since  one  item  may  be  chargeable  to  capital,  while 
another  item  of  exactly  the  same  nature  may  be  chargeable  to 
income,  the  distinction  depending  entirely  on  the  purpose  for 
which  used. 

All  well-regulated  concerns  have  a  storeroom  system,  which 
means  that  most  debits  to  plant  accounts  originate  in  storeroom 
charges.  It  is  simply  impossible  to  determine  long  afterward, 
by  a  mere  inspection  of  the  voucher,  whether  it  should  be  charged 
to  one  account  or  another. 

Method  of  Verification. — ^The  most  satisfactory  verifica- 
tion is  to  secure  a  dependable  memorandum  of  the  additions  and 
improvements  which  have  been  undertaken  or  completed  in 
order  to  increase  the  earning  power  or  efficiency  of  the  plant. 
That  is,  if  a  new  building  has  been  erected  or  a  new  power  plant 


THE  DETAILED  AUDIT  587 

installed,  assemble  all  of  the  items  applicable  thereto^  and  com- 
pare the  expenditure  as  a  whole  with  the  estimated  value  of  the 
improvement,  or  the  official  authorization.  Ascertain  what  it 
replaced,  and  what  additional  capacity  or  economies  are  effected. 
Odds  and  ends  should  not  be  charged  to  capital,  so  that  the 
increase  in  plant  accounts  for  a  given  period  should  be  reducible 
to  definite  grouping  as  indicated  above.  If  it  is  found  that  the 
total  capacity  of  the  plant  is  not  materially  increased  by  the  out- 
lay, it  may  be  inferred  that  the  changes  were  necessary  to  renew 
or  replace  worn-out  or  obsolete  buildings  or  equipment. 

Profits  Earned  Prior  to  Purchase  of  Capital  Assets. — 
Where  a  corporation  purchases  during  the  fiscal  year  the  net 
assets  of  another  corporation,  that  is,  takes  over  the  assets  and 
assumes  the  liabilities  with  a  further  provision  that  the  purchas- 
ing corporation  will  receive  the  profits  earned  since  the  close  of 
the  previous  period,  this  profit  after  it  is  determined  is  not  income 
but  capital.  It  is  impossible  to  realize  a  profit  until  after  the  ac- 
quisition of  property.  It  may  immediately  be  resold  at  a  profit, 
but  that  constitutes  a  new  transaction.  The  cost  of  property  is 
its  net  cost.  Profit  accrued  up  to  date  of  acquisition,  or  surplus 
from  reappraisals,  are  merely  adjustments  which  affect  the  net 
purchase  price;  current  or  earned  surplus  is  not  affected. 

Cash  Discounts  on  Capital  Payments 

It  is  held  by  some  that  the  cash  discounts  deducted  from  pay- 
ments on  account  of  capital  outlay  should  be  credited  to  interest 
or  discount  account  and  be  treated  as  an  earning.  This,  however, 
is  a  fallacy,  as  will  be  shown  by  a  concrete  example.  Suppose  a 
fund  of  $10,000  is  set  aside  to  buy  machinery;  the  invoices  may 
aggregate  exactly  $10,000  and  are  subject  to  a  discount  of  2  per 
cent  if  paid  within  ten  days.    Advantage  is  taken  of  the  discount 

3  Among  the  elements  which  enter  into  cost  new  and  cost  of  reproduction 
are  the  following:  organization,  legal  and  engineering  expenses,  interest,  dir- 
count,  taxes  and  insurance  during  construction,  city  inspection,  brokerage, 
and  contractor's  profit  or  compensation. 


588  AUDITING— GENERAL  PRINCIPLES 

and  $9,800  is  paid  out.  It  cannot  be  contended  that  the  cost  is 
$10,000  and  that  an  earning  of  $200  is  realized,  because  such  is 
not  the  fact.  The  machinery  cost  $9,800  in  cash,  and  the  cash 
balance  which  remained  is  simply  an  unexpended  fund.  It  has 
not  been  used  and  is  now  available  for  other  purposes.  This  is 
parallel  with  the  treatment  of  cash  discounts  on  merchandise 
purchases,  the  net  result  being  the  same  because  the  purchases 
account  is  ultimately  reduced  by  the  amount  of  the  discount 
through  the  income  account. 

Real  Estate 

In  any  business  other  than  that  of  realty,  there  are  few  items 
of  cash  payments  in  connection  with  the  purchase  of  land  or  im- 
proved real  estate.  More  frequently  it  is  found  that  bonds  or 
stocks  are  issued  in  payment  therefor.  Usually  these  items  can 
be  vouched  from  the  minutes  of  boards  of  directors,  the  contracts 
themselves,  and  the  acknowledgments  of  the  payees. 

An  instance  is  known  of  a  promoter  who  was  made  the  presi- 
dent of  a  holding  company  who  paid  himself,  as  representing  one 
of  the  subsidiaries,  a  larger  number  of  bonds  than  he  was  entitled 
to.  The  records  of  the  holding  company  were  altered  to  fit  the 
transaction  and  the  auditors  were  deceived.  If  the  books  of  the 
subsidiary  company  had  been  examined,  the  fraud  would  have 
been  discovered. 

Buildings  '  . 

Where  a  considerable  amount  is  being  expended  on  new  or  old 
buildings,  the  payments  should  be  carefully  vouched.  Individual 
payments,  however,  will  probably  be  supported  by  genuine- 
looking  vouchers  and  will  not  reveal  any  irregularity  which  may 
be  going  on,  either  on  the  part  of  the  client's  staff  or  on  the  part 
of  the  contractor.  Therefore,  the  operations  as  a  whole  should  be 
checked  with  the  authorizations  of  the  board  of  directors,  or  ex- 
ecutives in  charge  of  the  work,  and  with  the  bids  or  estimates 
submitted  before  work  was  commenced. 


THE  DETAILED  AUDIT  589 

What  to  Capitalize. — It  is  permissible  to  charge  all  expenses 
and  outlays,  such  as  permits,  architects'  and  engineers'  fees 
clerical  salaries  when  clearly  applicable  to  new  work,  and  similar 
items,  to  the  work  itself.  It  may  seem  more  conservative  to 
charge  part  of  this  expenditure  to  revenue,  but  in  all  cases  it  is 
preferable  to  assemble  all  costs  into  one  account;  then  if  it  appears 
desirable  to  write  off  a  part  of  the  cost,  it  can  be  done  at  any  time. 
The  whole  cost,  however,  having  once  appeared  in  one  account, 
is  subsequently  available  for  any  desired  information. 

Profit  Excluded. — ^Where  new .  buildings  are  erected,  in 
whole  or  in  part,  by  the  concern  itself,  it  is  important  to  ascertain 
that  no  profit  is  included.  Auditors  frequently  find  this  state  of 
affairs  and  are  met  with  the  argument  that  if  the  contract  had 
been  awarded  to  an  outside  concern,  a  contractor's  profit  would 
have  been  added.  A  concern  not  in  the  contracting  business 
cannot  always,  however,  erect  a  building,  or  in  fact  perform  any 
work  outside  of  its  usual  operations,  at  the  same  cost  as  can  one 
whose  sole  efforts  are  devoted  to  this  class  of  work  and  who  may 
be  depended  upon  to  have  discovered  economies  in  purchasing, 
planning,  and  executing  not  possible  except  after  long  experience. 
If  an  actual  saving  has  been  effected,  it  is  not  a  realized  profit  and 
should  not  be  treated  as  such.  The  asset  account  should  represent 
cost,  but  nothing  more.  The  following  is  from  the  Federal  Re- 
serve Bulletin,  April,  191 7: 

While  it  may  be  considered  permissible  to  make  a  charge  for  factory 
overhead  cost  to  additions  to  property  such  as  e.g.  time  of  superintendent 
and  his  clerical  force  employed  on  construction  work,  etc.,  it  cannot  be 
deemed  conservative  business  practice,  inasmuch  as  the  probabilities  are 
that  the  overhead  charges  of  a  plant  will  not  be  decreased  to  any  extent 
even  though  additions  are  not  under  way,  and,  therefore,  the  absorption 
of  part  of  these  charges  when  additions  are  in  progress,  has  the  effect  of 
reducing  the  operating  costs,  as  compared  with  months  in  which  no  con- 
struction work  is  under  way. 

Interest. — Cost,  however,  may  include  (during  the  construc- 
tion period)  interest  paid  on  borrowed  money  used  for  construe- 


590  AUDITING— GENERAL  PRINCIPLES 

tion  purposes.  Otherwise  a  concern  may  find  that  a  profit  and 
loss  deficit  existed  with  respect  to  a  new  plant,  before  its  comple- 
tion. After  completion  a  plant  is  expected  to  earn  a  sufficient 
profit  to  cover  interest,  but  it  is  unreasonable  to  apply  such  a  rule 
before  its  earning  power  becomes  possible. 

The  accounting  practice  of  charging  interest  to  construction 
produces  imequal  results  so  far  as  comparative  records  are  con- 
cerned. One  concern  erects  a  plant  with  borrowed  money; 
another  concern  uses  its  own  capital.  Other  things  being  equal, 
the  book  records  show  that  one  plant  costs  more  than  the  other. 
Subsequent  depreciation  charges  of  one  are  more  than  the  other; 
nevertheless  the  books  merely  record  the  facts.  Upon  the  be- 
ginning of  operations  neither  concern  showed  a  loss  or  a  profit; 
subsequently  the  operating  costs  of  one  are  less  than  the  other — 
as  they  should  be.  The  benefit  is  equivalent  to  a  return  on  the 
concern's  original  investment  of  its  own  capital. 

When  questions  of  rate-making  or  public  supervision  are  in 
issue,  an  adjustment  of  book  costs  is  required.  Both  concerns 
should  be  treated  the  same.  To  the  book  cost  of  one  should  be 
added  an  amount  equal  to  a  fair  rate  of  interest.  After  the 
beginning  of  operations  both  concerns  will  then  be  on  the  same 
footing.  The  allowance  for  rate-making  does  not  commence  until 
construction  is  complete  or  operations  begin.  If  the  adjustment 
is  shown  in  the  books  (which  is  not  necessary)  the  corresponding 
credit  is  to  capital  surplus;  the  income  account  and  rate-making 
are  not  affected. 

Instalments  Due. — The  auditor  should  ascertain  whether  in- 
stalments are  due  on  contracts  in  progress.  The  liabilities  for  such 
instalments  should  appear  on  the  balance  sheet  because  they  should 
be  considered  in  connection  with  the  amount  of  current  assets. 

Improvements  and  Extensions 

These  terms  are  descriptive  in  themselves,  but  they  are  hard 
to  define  in  practice;  that  is,  hard  for  an  auditor  to  define.    An 


THE  DETAILED  AUDIT  591 

executive  or  the  man  in  charge  of  the  job  has  no  such  difficulty. 
Before  the  era  of  high  tax  rates  every  new  job  was  an  improvement, 
an  addition,  or  an  extension,  and  the  entire  cost  was  capitalized. 
Since  the  incidence  of  high  tax  rates  the  tendency  to  capitalize 
all  so-called  improvements  has  greatly  lessened.  The  fact  is  that 
practically  no  part  of  a  plant  is  renewed  or  replaced  in  exactly  its 
former  state.  Almost  invariably  it  is  enlarged  or  otherwise 
changed  for  the  better,  so  that  there  is  some  basis  for  the  difficulty 
of  determining  what  to  do.  If  there  is  no  increased  earning 
capacity  the  question  is  simplified,  but  even  here  we  cannot  lay 
down  the  hard-and-fast  rule  that  no  part  of  the  new  cost  must  be 
capitalized. 

Illustration. — Suppose  a  railroad  company  demolishes  an 
old  wooden  station  and  erects  in  its  place  a  larger  and  more  ornate 
structure  of  brick  and  stone,  at  a  cost  which  is  $100,000  in  excess 
of  the  book  value  of  the  old  building.  It  may  be  assumed  that 
the  earning  capacity  is  not  materially  increased;  probably  the 
maintenance  cost  of  the  new  structure  is  greater  than  that  of  the 
old.  The  argument  will  be  used  that  the  traveling  public  de- 
mands beauty  as  well  as  utiHty;  and  there  is  an  actual,  if  almost 
imperceptible,  increased  earning  potentiality  in  the  more  hand- 
some structure. 

The  same  point  arises  in  connection  with  manufacturing  con- 
cerns. Large  and  expensive  office  buildings,  recreation  facilities, 
and  similar  expenditures  are  made  without  any  apparent  increase 
in  earning  capacity. 

Procedure  to  Follow. — The  auditor  must  decide  each  case 
on  its  merits.  Wherever  possible  such  expenditures  should  be 
charged  to  expenses.  If  the  expenditures  are  large  and  of  infre- 
quent occurrence,  it  may  be  permissible  to  spread  them  over  a 
period  of  two  to  five  years.  This  may  seem  to  be  rather  drastic 
practice,  but  between  the  alternative  of  loading  the  plant  accoimt 
to  the  danger  point — as  so  often  happens — and  keeping  it  down 


592  AUDITING— GENERAL  PRINCIPLES 

to  a  safe  and  sane  basis,  there  should  be  little  argument  as  to 
which  is  better  accounting. 

Managerial  Salaries. — Another  somewhat  imcertain  point 
in  plants  where  improvements  or  extensions  are  being  made  at 
intervals,  is  the  selection  of  the  proper  account  to  which  the  salary 
of  a  manager  or  a  superintendent  should  be  charged.  It  may  be 
that  the  entire  time  of  these  officials  is  devoted  to  the  new  con- 
struction while  it  is  going  on,  and  so  there  may  be  some  justifica- 
tion for  capitalizing  part  of  such  cost. 

Here  again  is  a  case  of  doubt  which  should  be  decided  in  favor 
of  conservative  practice.  As  heretofore  stated,  work  of  this 
nature  performed  partly  or  entirely  by  a  concern  not  in  the  build- 
ing trade,  usually  costs  more  than  if  contracted  for  outside. 
There  may  be  good  reasons  for  not  having  the  work  done  outside, 
but  there  is  no  good  reason  for  running  up  the  book  cost  beyond 
its  replacement  value. 

If  left  to  the  auditor  to  decide,  he  should  not  load  the  plant 
account  with  any  general  expense  items  such  as  managers'  or 
superintendents'  salaries. 

Machinery,  etc. 

.The  important  point  to  keep  in  mind  in  connection  with  pur- 
chases of  machinery,  tools,  fixtures,  etc.,  is  whether  they  represent 
actual  additions  to  plant  and  equipment,  or  whether  they  are 
renewals.  This  point  is  covered  in  Chapter  XXVIII,  ''Depre- 
ciation." The  cost  of  installation,  including  freight,  labor,  and 
other  items,  is  as  much  a  part  of  the  cost  as  the  price  of  the  ma- 
chinery itself. 

Where  machines,  etc.,  are  built  by  the  concern  itself,  the  re- 
marks found  above  under  "Buildings"  will  also  apply. 

Instalment  Plan. — ^Where  machines  have  been  purchased 
upon  the  partial  payment  or  instalment  plan,  it  is  customary  to 
charge  the  entire  purchase  price  to  the  machinery  account  and 
credit  the  vendor.    As  the  monthly  or  other  periodical  payments 


THE  DETAILED  AUDIT  593 

are  made  the  vendor's  account  is  charged  and  finally  closed. 
Interest  is  usually  included  in  the  gross  purchase  price,  but  of 
course  does  not  form  part  of  the  price  if  cash  is  paid.  The  proper 
entry  is  to  debit  machinery  with  the  cash  price,  and  debit  the 
interest  account  with  the  balance. 

On  the  balance  sheet,  if  prepared  before  the  last  payment  is 
made,  the  value  of  the  machinery  less  depreciation  should  be 
shown  among  the  assets,  with  the  facts  as  to  the  lien  clearly 
shown  in  the  face  of  the  balance  sheet.  The  unpaid  instalments 
are,  to  some  extent  at  least,  current  liabilities  and  must  be  so 
included. 

If  the  payments  extend  over  several  years,  the  interest  applic- 
able to  subsequent  years  may  be  set  up  as  a  deferred  charge.  If 
at  the  time  the  balance  sheet  is  prepared,  any  instalments  are 
overdue,  or  if  they  have  not  been  paid  promptly,  it  may  be  that 
the  equity  will  be  lost  through  the  retaking  of  the  machines  by 
the  manufacturer.  This  possibility  must  be  considered  in  valuing 
the  item. 

Royalty  Payments. — Machines  are  sometimes  purchased 
under  an  agreement  that  a  royalty  will  be  paid  on  the  output. 
The  royalty  payments  should  be  charged  to  operating  expenses. 
They  have  no  connection  with  the  purchase  price  so  far  as  the 
books  are  concerned.  The  value  of  the  machine  is  set  up  as  an 
asset  and  depreciated  on  the  basis  of  the  effective  life  of  the 
machine. 

Notes  Payable 

All  notes  paid  during  the  period  under  audit  should  be  sub- 
mitted as  vouchers.  If  notes  are  issued  from  a  stub  book,  or  if  a 
special  form  is  used,  all  should  be  accounted  for.  Spoiled  notes 
should  be  pasted  on  their  respective  stubs  as  is  done  with  cheques. 

If  careful  consideration  is  given  to  the  notes  issued  during  the 
period,  it  will  assist  the  auditor  to  determine  whether  all  notes 
outstanding  at  the  date  of  the  balance  sheet  appear  thereon. 

VOL.  I — 38 


594  AUDITING— GENERAL  PRINCIPLES 

Unrecorded  Notes  Payable. — In  a  detailed  audit  the 
auditor  finds  better  opportunities  for  securing  information  rela- 
tive to  notes  payable  outstanding,  but  omitted  from  the  books, 
than  in  the  case  of  a  balance  sheet  audit.  In  the  former  case 
scrutiny  of  cash  receipts,  interest,  discount,  bonuses  paid,  and 
credits  to  the  personal  accounts  of  partners  and  officers  of  cor- 
porations, may  disclose  clues  as  to  unentered  or  misapplied 
liabilities.  Creditors  should  be  asked  to  confirm  the  amount  of 
the  liability  on  notes  as  well  as  on  accounts.  Purchases  of  fixed 
assets  are  sometimes  made  by  giving  notes  which  may  still  be 
outstanding.  The  asset  accounts  may  be  charged  for  only  the 
amount  paid  or  for  the  full  face  value  of  the  notes. 

An  auditor  had  completed  his  examination  and  was  about  to 
deliver  the  report  when  he  accidentally  stopped  in  at  a  bank  on 
the  way  to  the  client's  office.  The  cashier  spoke  of  the  audit  and 
inquired  whether  the  auditor  thought  that  a  note  for  $15,000,  due 
the  following  month,  would  be  paid.  The  auditor  knowing  that 
no  such  item  appeared  on  the  balance  sheet  nor  in  the  books, 
asked  to  see  the  note.  He  found  that  it  was  a  company  note 
executed  by  the  treasurer,  who  had  received  and  misappropriated 
the  proceeds  without  passing  any  entry  therefor  through  the 
books.  The  auditor  would  have  detected  the  fraud  had  he  asked 
the  bank  if  it  held  any  obligations  of  the  company. 

Indorsements. — In  checking  up  the  canceled  or  paid  notes  the 
indorsements  should  be  examined.  Many  notes  are  made  to  the 
order  of  and  indorsed  by  the  payee,  but,  if  discounted,  bear  the 
rubber  stamp  indorsement  or  cancellation  mark  of  the  bank.  If 
there  are  no  such  marks,  inquiry  should  be  made,  although  an 
overdue  note  can  hardly  cause  m.uch  trouble. 

See  page  593  for  a  more  complete  discussion  of  notes  payable. 

Partners'  Withdrawals 

If  payments  are  made  in  currency,  partners  should  approve 
their  accounts  as  they  appear  in  the  ledger. 


THE  DETAILED  AUDIT  595 

The  practice,  so  prevalent,  of  drawing  comparatively  small 
amounts  at  a  time  and  initialing  a  voucher,  or  declining  to  give 
one  at  all,  is  a  direct  temptation  to  dishonesty  on  the  part  of  the 
cashier.  Auditors  should  criticize  the  practice  vigorously  and  sug- 
gest to  partners  that  their  withdrawals  be  by  cheque  only,  and  that 
they  pay  their  personal  bills  through  their  own  bank  accounts. 

Dividends 

The  audit  of  dividend  payments  is  simple.  Authorization 
must  always  be  found  in  the  board  minutes,  and  any  dividend 
declared,  if  paid,  must  be  paid  to  all  stockholders  of  record  at  the 
date  named.  Dividends  cannot  be  declared  as  of  a  past  date,  but 
may  be  dated  ahead  as  far  as  may  be  desired. 

In  the  case  of  Jones  v.  Terre  Haute  &"  Richmond  R.  R.  Co.,^ 
Commissioner  Reynolds  said : 

It  is  certainly  true,  as  a  general  rule,  that  a  stockholder  in  a  corporation 
has  an  interest,  in  proportion  to  his  stock,  in  all  the  corporate  property,  and 
has  a  right  to  share  in  any  surplus  of  profits  arising  from  its  use  and  em- 
ployment in  the  business  of  the  company;  and  this  legal  right  does  not 
depend  upon  the  question  whether  he  is  a  stockholder  of  long  standing  or 
of  recent  date.  The  moment  a  person  becomes  stockholder  in  a  corpora- 
tion, all  the  incidents  of  interest  or  quasi-ownership  in  the  corporate 
property  attach. 

In  another  New  York  case  the  court  refused  to  order  the 
directors  to  pay  additional  dividends,  although  the  corporation 
had  a  very  large  surplus,  part  of  which  was  in  bank  and  repre- 
sented a  sum  far  in  excess  of  that  actually  required  for  current 
purposes,  and  part  of  which  was  invested  in  outside  securities. 
The  court  said:  ^'The  discretion  of  the  directors  in  regard  to 
declaring  dividends  will  not  be  interfered  with  in  the  absence  of 
fraud  or  an  abuse  of  discretion." 

Dividends  on  Preferred  Stock. — Questions  arise  regarding 
preferred  stock  which  do  not  arise  in  connection  with  common 

457N.Y.  196. 


596  AUDITING— GENERAL  PRINCIPLES 

or  no-par  value  stock.  Agreements  between  corporations  and 
holders  of  preferred  stock  are  in  effect  between  the  holders  of 
common  and  preferred  stock.  It  is  entirely  legal  to  agree  to  pay 
I  GO  per  cent  per  annum  on  preferred  stock  before  anything  is  paid 
or  accrues  to  common  stock;  preferences  as  to  assets  and  retire- 
ment are  limited  only  by  the  ingenuity  of  lawyers  and  those  who 
seek  new  capital.  It  lies  in  the  discretion  of  directors  whether  or 
not  to  pay  accumulations  of  dividends  on  preferred  stock;  the 
only  reasons  for  compelling  dividends  are  fraud  and  accumula- 
tions of  funds  far  in  excess  of  reasonable  requirements.  ^ 

When  preferred  stock  is  issued  at  various  times,  it  is  legal  and 
proper  to  apportion  the  dividends  payable  to  stockholders  who 
have  not  held  their  stock  for  as  long  periods  as  others.  ^ 

Stock  Dividends. — Dividends  are  supposed  to  be  distribu- 
tions of  earnings  and  accrue  to  the  stockholder  only  at  the  time 
of  declaration.  A  stockholder  in  a  corporation  having  a  large 
surplus  and  earning  several  times  the  amount  of  its  dividends,  is 
no  more  justified  in  taking  a  proportionate  part  of  an  expected 
dividend  into  his  accounts  as  income  than  he  would  be  in  assum- 
ing that  the  entire  surplus  would  be  divided.  When  the  dividend 
is  actually  declared  and  becomes  an  obligation  of  the  corporation, 
it  becomes,  in  turn,  income  receivable  to  the  stockholder.  When 
the  distribution  includes  the  surplus  of  two  or  more  years  which, 
as  a  matter  of  fact,  has  been  capitalized,  when  dividends  are  paid 
in  corporation's  own  stock  such  dividend  (or  the  proceeds)  cannot 
always  be  regarded  as  current  income. 

The  Standard  Oil  Company  of  Indiana  declared  a  stock 
dividend  of  2,900  per  cent;  that  is,  the  holder  of  $100  in  stock 
received  additional  stock  amounting  to  $2,900.  Suppose  the 
owner  of  one  share  died  shortly  before  the  declaration  of  the 
dividend,  leaving  the  income  of  his  estate  to  his  wife  for  life  and 
the  principal  to  his  children,  the  stock  would  have  been  appraised 

s  N.  K,  L.  E.  &  W.  R.  R.  Co.  v.  Nickals,  1 19  U.  S.  296;  30  L.  Ed.  363  (1886), 
<*  Utka  Trust  &  Dep.  Co.  v,  Kellogg  &  Sons  Co.,  126  App.  Div.  (N.Y.)  176. 


THE  DETAILED  AUDIT  597 

at  perhaps  $2,000,  based  on  earnings  of,  say,  20  per  cent  per 
annum  on  that  price.  If  the  principle  that  dividends  are  income 
were  applied,  the  widow  would  receive  the  $2,900  per  share  in 
new  stock,  and  at  her  death,  if  no  other  change  took  place,  the 
children  would  receive  the  original  share,  worth  now  only  $100 
and  yielding  perhaps  10  per  cent  per  annum.  This  would  be  so 
inequitable  and  so  at  variance  with  the  testator's  intentions  that 
most  of  the  states  would  permit  the  dividend  to  be  treated  as  a 
distribution  of  principal  and  not  of  income. 

Precisely  the  same  rule  should  apply  when  stocks  are  carried 
on  balance  sheets  at  very  high  figures  and  are  reduced  in  price 
per  share  through  the  distribution  of  large  stock  dividends. 
Unless  it  is  very  clear  that  the  declaration  consists  of  the  earnings 
of  a  recent  period,  the  whole  dividend  should  be  treated  as  capital. 
If  it  can  be  apportioned,  it  is  proper  to  apply  that  part  of  it  repre- 
senting a  distribution  of  the  earnings  of  the  last  year  or  period  to 
current  income.  Where  state  laws  govern  the  matter  the  laws 
must  be  observed.  The  auditor  should  be  thoroughly  informed  as 
to  the  provisions  of  the  law  in  this  respect  in  his  own  state  and  in 
any  others  where  he  practices. 

The  Supreme  Court  of  the  United  States  has  decided  that 
stock  dividends  are  not  taxable  income;  the  highest  courts  in 
several  states  have  decided  that  stock  dividends  are  taxable 
income.  When  tax  liability  is  in  question,  federal  as  well  as  state 
procedure  must  be  considered,  otherwise  the  dividends  should  be 
apportioned  as  suggested  in  the  foregoing  illustration. 

Capital  Stock 

A  trial  balance  should  be  taken  of  the  stock  ledger  to  see  that 
the  aggregate  amoimt  outstanding  is  in  agreement  with  the 
general  ledger  account.  It  should  be  noted  if  there  is  any  ac- 
count in  the  name  of  the  company  or  its  treasurer  which  was 
intended  to  represent  treasury  stock,  but  which  may  or  may  not 
be  such. 

The  stock  certificate  books  should  be  examined  and  reconciled 


598  AUDITING— GENERAL  PRINCIPLES 

with  the  stock  ledger.  All  canceled  certificates  should  be  in- 
spected or  accounted  for.  Large  corporations  usually  register 
their  stock;  in  such  cases  the  auditor  should  request  a  certificate 
from  the  registrar.  When  the  aggregate  number  of  shares  shown 
to  be  outstanding  agrees  with  the  books,  it  is  not  necessary  to  take 
a  trial  balance  of  the  stock  ledger. 

Bonds 

A  proof  should  be  taken  of  the  bond  ledger  or  register  to 
ascertain  that  the  aggregate  outstanding  is  correct  and  is  in  agree- 
ment with  the  general  ledger.  Canceled  bonds  should  be  in- 
spected or  accounted  for.  The  bond  agreement  should  be  read, 
and  if  it  contains  any  provisions  as  to  sinking  funds,  etc.,  the 
auditor  should  ascertain  that  these  are  carried  out  or  a  report 
made  thereon. 

All  bonds  which  have  been  certified  by  the  trustee  and  de- 
livered to  the  corporation  must  be  accounted  for.  If  they  have 
been  sold  for  cash  or  issued  for  property,  the  handling  of  the 
proceeds  should  be  followed  to  see  that  proper  entries  have  been 
Aiade  therefor,  thus  rendering  a  subsequent  audit  possible.  If 
any  bonds  have  not  been  sold  but  are  supposed  to  be  on  hand  as 
treasury  bonds,  the  auditor  should  ask  to  see  them.  Frequently 
treasury  bonds  are  deposited  as  collateral  for  loans,  and,  since  this 
fact  must  appear  on  the  balance  sheet,  the  auditor  should  be  sure 
to  ascertain  the  facts. 

It  should  be  determined  whether  or  not  the  amount  of  in- 
terest accrued  has  been  set  up  in  the  accounts  and  whether  the 
amount  due  has  been  paid.  Careful  methods  should  be  in  force 
relative  to  coupons.  They  should  be  canceled  effectively  imme- 
diately upon  receipt,  and  kept  on  file,  not  destroyed.  The  auditor 
should  see  that  the  canceled  coupons  are  accounted  for. 

Taxes 

Corporations  are  subject  to  special  taxes,  such  as  the  federal 
income  and  war  taxes,  state  franchise  tax,  etc.     The  auditor 


THE  DETAILED  AUDIT  599 

should  see  that  these,  as  well  as  the  usual  taxes  on  property,  are 
provided  for,  and  that  a  liability  or  a  reserve  for  the  tax,  based 
on  the  income  of  the  year  under  review,  is  included  in  the  balance 
sheet. 

In  New  York  State  there  is  a  tax  of  two  cents  per  hundred 
dollars  of  par  value  or  fraction  thereof,  imposed  on  all  transfers  of 
stock.  The  seller  of  the  stock,  or  his  broker,  pays  this  tax  by 
affixing  revenue  stamps  to  the  certificate  surrendered.  The  officer 
of  the  corporation,  however,  who  transfers  the  stock  or  causes  it 
to  be  transferred  is  liable  for  the  penalty  for  failure  to  pay  the  tax. 


CHAPTER  XXVII 

OFFICE  AND   ACCOUNTING  METHODS 

A  professional  auditor  is  not  expected  to  perform  the  functions 
of  a  cost  accountant  nor  to  reorganize  office  methods.  Yet  in 
detailed  audits  criticisms  and  suggestions  are  not  only  in  order 
but  are  looked  upon  as  part  of  the  auditor's  duties.  It  is  not 
expected  that  a  short  discussion  of  office  and  accounting  methods 
will  take  the  place  of  a  complete  study  of  these  important  sub- 
jects, nor  is  it  intended  to  do  more  than  mention  some  of  the 
important  features  of  systems  and  methods.  The  professional 
auditor  can  and  should  make  notes  of  what  he  finds  during  the 
progress  of  an  audit.  Frequently  so  much  carelessness  and 
inefficiency  are  found  that  a  complete  reorganization  is  necessary. 
In  other  cases  less  drastic  means  are  necessary.  In  any  case, 
the  professional  auditor  who  has  an  intelligent  sense  of  the 
"high  spots"  to  be  covered  (even  though  he  is  not  a  speciaUst) 
will  perform  more  useful  service  than  if  he  were  to  avoid  dis- 
cussion of  systems  and  methods  on  the  ground  that  a  little 
knowledge  is  a  dangerous  thing. 

OFFICE   METHODS 

In  nearly  every  audit  where  no  previous  work  had  been  done 
for  the  client,  the  auditor  was  formerly  asked  to  note  any 
improvements  or  changes  which  might  occur  to  him  during  the 
progress  of  the  audit.  It  did  not  seem  incongruous  that  a 
professional  accountant  whose  whole  time  is  spent  in  examining 
and  criticizing  accounts  should  in  the  course  of  an  extensive 
practice  acquire  experience  of  great  value,  and  that  he  should 
be  able  to  give  to  new  clients  the  benefit  of  such  experience.  At 
the  present  time  there  is  somewhat  of  a  feeling  that  the  auditor  is 

600 


OFFICE  AND  ACCOUNTING  METHODS  6oi 

not  a  specialist  in  system  work  and  that  in  order  to  be  up-to-date 
an  'industrial  engineer"  must  be  employed.  But  suppose  we 
compare  present  conditions  with  those  of  about  fifteen  years  ago. 
At  that  time  stationery  houses,  which  carried  an  "auditing 
department"  as  a  side  line,  were  making  a  great  stir  through 
advertising  and  traveling  solicitors,  and  were  offering  to  produce 
wonderful  results,  including  daily  balance  sheets  and  income 
statements,  the  only  requirement  being  the  installation  of 
their  patented  stationery.  Offices  were  turned  inside  out  and 
new  books  and  blanks  were  installed  by  the  ton,  but  for  some 
reason  the  service  did  not  measure  up  to  the  promises,  and  hun- 
dreds of  offices  discarded  much  of  the  ''junk"  which  had  been 
thrust  upon  them  and  went  back  to  saner  methods. 

For  a  short  time  the  auditor  was  back  in  favor.  He  had  no 
cut-and-dried  system,  nor  did  he  know  before  he  entered  an  office 
how  its  system  should  be  mapped  out;  but  out  of  long  experience 
he  was  able  to  make  suggestions  which  cut  out  imnecessary  work 
and  proposed  changes  which  embraced  the  use  of  all  the  latest 
labor-saving  devices.  Then  came  the  "efficiency  engineer,"  who 
again  modestly  affirmed  that  the  auditor  was  not  a  specialist 
in  systems  and  that  he  could  not  be  expected  to  keep  his  client 
up-to-date.  The  crop  of  overcharged  and  dissatisfied  patrons  of 
the  "efficiency  engineer"  is  being  heard  from,  and  it  is  beheved 
by  many  who  have  studied  the  situation  that  the  auditor  is 
coming  back  to  his  former  position  as  a  recognized  authority  on 
business  systems. 

The  auditor  should  keep  fully  informed  on  the  latest  devices, 
mechanical  and  otherwise,  for  saving  labor  or  rendering  it  more 
efficient;  he  should  understand  and  be  prepared  to  explain  the 
relation  of  one  department  of  a  business  to  another  and  the 
advantages  of  co-ordination ;  he  should  study  cost  systems  and  be 
ready  to  install  any  required  accounting  system;  he  should 
acquire  and  follow  up  a  knowledge  of  the  means  of  imparting 
information  by  means  of  charts  and  other  visual  methods. 

It  may  be  urged  that  an  auditor  cannot  hope  to  cover  more 


602  AUDITING— GENERAL  PRINCIPLES 

than  a  small  part  of  the  field  of  auditing  within  a  considerable 
period  of  practice  and  that  to  expect  him  to  take  over  the  work 
of  a  system  specialist  is  unreasonable.  The  answer  to  this  is  that 
no  one  can  be  a  good  auditor  without  picking  up  all  of  the  rudi- 
ments of  systematizing,  and  that  in  any  event  system  is  a  matter 
of  evolution. 

Ready-made  systems  have  been  popular,  but  never  successful. 
No  system  works  out  well  unless  a  good  man  studies  the  concern 
and  becomes  acquainted  with  its  personnel  before  he  starts,  and 
then  *'  lives. with  the  job  "  until  its  completion.  The  auditor  may 
not  be  able  to  handle  many  such  engagements,  but  he  should  not 
allow  the  so-called  system  experts  to  bluff  him  out  of  remimer- 
ative  work.  He  is  probably  better  qualified  to  perform  it  than 
anyone  else. 

Styles  of  Books  and  Records 

The  auditor  should  note  by  actual  inspection  whether  or  not 
the  records  are  kept  economically  and  efficiently.  If  the  old- 
fashioned  bound  books  are  in  use  and  if  loose-leaf  records  would 
be  an  improvement,  he  should  recommend  the  change.  On  the 
other  hand,  it  may  be  that  some  records  are  being  kept  on  cards 
or  loose  leaves  which  could  be  written  up  more  readily  and 
referred  to  more  easily  in  bound  books.  In  such  a  case  the  latter 
should  be  recommended. 

In  view  of  the  elasticity  and  convenience  of  cards  and  loose- 
leaf  records,  these  systems  are  becoming  more  and  more  popular. 
In  the  early  stages  of  their  use  it  was  feared  that  the  leaf  or  card 
might  be  lost,  destroyed,  or  easily  altered,  but  after  a  number  of 
years  of  experience  this  fear  has  practically  disappeared. 

Books  as  Evidence 

Aside  from  the  question  of  fraud,  it  is  always  desirable  that 
books  and  records  be  kept  neatly  and  accurately,  and  that  they 
be  complete  and  co-ordinate.  In  other  words,  there  can  be  no 
possible  argument  against  accurate  and  creditable  books  of 


OFFICE  AND  ACCOUNTING  METHODS  603 

account,  but  serious  loss  may  result  from  inaccurate  and  incom- 
plete records.  In  the  course  of  time  a  considerable  number  of 
business  enterprises  are  compelled  to  engage  in  litigation,  either 
as  plaintiffs  or  defendants,  in  which  the  books  of  account  must 
be  produced  and  offered  in  evidence,  and  many  cases  are  lost 
through  lack  of  evidence  on  some  vital  point  on  account  of 
insufficient  or  discreditable  data. 

The  auditor  has  many  opportunities  of  dealing  with  the 
wrong  kind  of  books,  which  experiences  will  serve  as  examples 
when  he  tells  his  clients  what  not  to  do. 

Loose-Leaf  Records 

It  was  formerly  held  that  loose-leaf  records  were  not  proper 
and  sufficient  evidence,  by  reason  of  the  supposed  danger  of 
substitution,  but  business  custom  and  convenience  forced  a 
change,  so  that  today  these  records,  when  bearing  on  their  face 
all  the  signs  of  regularity,  are  admitted  without  question. 

The  chief  point  to  bear  in  mind  in  any  event  is  the  effect  on  a 
jury.  Carelessly  kept  bound  books  may  have  an  adverse  effect, 
while  neatly  kept  loose-leaf  records,  in  binders,  may  impress  the 
jury  as  containing  complete  and  dependable  records  of  the  trans- 
actions in  question. 

Erasures 

The  matter  of  erasures  is  one  to  which  the  auditor  should  give 
some  attention.  It  directly  affects  the  neat-looking  pages  which 
some  bookkeepers  love,  but  it  may  be  laid  down  as  a  general  rule 
that  an  incorrect  figure  ruled  out,  and  with  the  correct  amount 
inserted  above,  always  stands  for  itself,  while  an  erasure  or  alter- 
ation is  sometimes  hard  to  understand.  If  it  should  develop  at 
some  later  day  that  the  altered  figure  is  one  required  to  base  an 
action  or  defense  upon,  the  position  of  the  clerk  responsible  there- 
for is  not  an  enviable  one. 

The  one  great  factor  is  accuracy,  and  to  this  beauty  must,  if 
there  is  need,  be  subordinated. 


604  AUDITING— GENERAL  PRINCIPLES 

Original  Records  Necessary 

The  foregoing  remarks  lead  up  to  a  consideration  of  the  value 
of  records  which  are  merely  transcripts  of  others,  or  to  which  the 
entries  in  other  books  have  been  posted. 

In  England  it  is  customary  to  keep  certain  original  records  in 
more  or  less  ''rough"  form,  and  subsequently  transfer  the  entries 
to  ''fair"  books.  In  such  a  case  the  moment  it  is  shown  that  a 
certain  book  is  merely  a  copy  of  another,  and  was  written  subse- 
quently, it  loses  most  of  its  value  and  the  original  record  is  called 
for.     If  destroyed,  the  entire  case  might  be  lost. 

This  possibility  contains  a  twofold  lesson:  It  emphasizes 
the  desirability  of  making  all  original  records  part  of  the  double- 
entry  system  of  accounts  without  rewriting,  and  in  addition 
insures  the  preservation  of  records  which  may  be  called  for  when 
least  expected. 

Mechanical  Devices  as  an  Aid  to  the  Auditor 

The  auditor  should  be  familiar  with  the  mechanical  devices 
which  are  used  to  record,  classify,  and  compile  data  in  business. 
Except  in  very  small  concerns  one  or  several  mechanical  devices 
are  always  found  in  use  and  to  a  large  extent  the  system  of 
internal  check  is  dependent  on  results  obtained  through  the  use 
of,  or  is  verified  by,  these  machines. 

An  examination  may  be  made  where  the  value  of  the  use  of 
machines  is  not  appreciated.  It  is  the  auditor's  duty  in  such 
cases  to  recommend  their  use  and  to  give  illustrations  and  expla- 
nations which  will  encourage  the  client  or  his  employees  to  at  least 
make  an  investigation  of  the  value  of  the  machines  which  should 
be  used  in  his  particular  case. 

The  auditor,  because  of  experience  in  many  concerns,  can 
testify  that  as  a  rule  the  records  in  those  establishments  which 
make  the  fullest  use  of  mechanical  devices  are  likely  to  be  accu- 
rate and  complete  and  that  in  such  places  final  reports  and 
statistics  are  generally  made  available  with  a  minimum  of  time 
and  effort. 


OFFICE  AND  ACCOUNTING  METHODS  605 

The  client  looks  to  the  auditor  to  keep  him  informed  relative 
to  the  changes  and  improvements  in  such  devices.  He  rightfully 
expects  the  expert  employed  at  least  to  mention  in  conversation 
that  a  certain  machine  is  apparently  being  used  to  advantage  in 
other  business  establishments  to  do  work  similar  to  that  which  is 
done  by  hand  or  inefficiently  in  the  client's  office. 

The  auditor  should  know  to  what  extent  he  can  rely  on 
mechanical  devices  as  dependable  aids  to  an  internal  check. 
He  should  also  know  when  to  recommend  or  suggest  the  use  of 
a  certain  machine.  For  these  purposes  he  must  have  not  only  a 
superficial  knowledge  of  the  original  use  for  which  the  machine 
was  intended  but  also  a  knowledge  of  special  uses  to  which  the 
machines  have  been  put  by  some  experienced  operators.  This 
information  he  may  obtain  either  through  his  contact  with  the 
work  of  the  machines  in  his  practice  or  from  the  representatives 
of  the  manufacturers. 

Some  of  the  types  of  machines  and  their  purposes  are 
mentioned  in  the  following  paragraphs.  There  is  also  given  a 
list  of  some  of  the  work  which  may  be  done  to  advantage  with  the 
aid  of  mechanical  devices  and  the  type  of  machines  which  may  be 
used  in  each  case. 

Adding  Machines — Listing.  This  type  of  machine  is  invaluable 
where  it  is  required  not  only  to  know  the  total  of  a  group  of  figures  but 
also  to  have  for  reference  or  verification  purposes  a  list  of  the  items 
making  up  the  total.  It  is  possible  with  some  machines  to  split  the 
keyboard  and  to  obtain  the  sum  of  two  columns  of  figures  at  the  same 
time. 

Computing  Machines.  These  can  be  used  to  prepare  summaries, 
to  make  or  verify  extensions,  and  to  perform  various  computations  involv- 
ing addition,  subtraction,  multiplication,  division,  percentages,  etc. 
Some  of  these  machines  are  so  constructed  that  where  it  is  necessary  to 
make  many  calculations  with  the  same  multiplicand,  such  amounts  once 
placed  in  the  machine  remain  until  all  calculations  are  completed,  thus 
diminishing  the  possibility  of  error  and  saving  considerable  time.  In 
addition  the  mult'.pliers  as  well  as  the  result  appear  in  the  machine  at  the 
end  of  each  calculation.    Manufacturers  of  all  types  of  machines  furnish 


6o6  AUDITING— GENERAL  PRINCIPLES 

specially  prepared  tables  which  facilitate  the  use  of  the  machines  and 
increase  the  speed  of  the  operations. 

Tabulating  and  Recording.  A  statistical  machine  or  group  of 
machines  which  combines  the  preparation  of  a  record,  the  analysis  and  the 
tabulation  of  the  data  recorded.  The  information  is  tabulated  by  punch- 
ing holes  in  cards.  These  cards  in  turn  are  sorted  automatically,  making  it 
possible  to  obtain  with  rapidity  an  endless  combination  of  figures  through 
the  use  of  cumulating  devices.  Some  of  these  machines,  in  addition,  have 
devices  from  which  the  details  and  results  may  be  obtained  in  written  form. 

Billing.  A  combination  of  typewriter  and  computing  machine  by 
means  of  which  an  invoice  is  written,  the  extension  and  footings  are  made, 
and  the  totals  of  the  invoices  for  a  period  are  obtained.  It  is  not  possible 
on  some  machines,  however,  to  make  the  extensions  automatically. 

Bookkeeping  Machines.  In  some  cases  the  bookkeeping  machine 
is  practically  a  billing  machine  with  the  addition  of  certain  devices  which 
make  it  possible  to  accumulate  the  debits  and  credits  and  to  record  the 
balance  after  each  set  of  transactions  is  entered.  This  type  of  machine 
is  supposed  to  be  self -balancing.  In  other  cases  the  bookkeeping  machine 
is  used  to  record  the  same  information  which  would  appear  in  an  ordinary 
ledger,  cumulating  the  debits  and  credits  and  recording  as  mentioned 
above.  These  machines  make  it  possible  to  prepare  many  other  records 
simultaneously;  for  instance,  invoices,  sales  book  entries,  journal  entries, 
etc. 

Statement  Machine.  These  machines  are  very  similar  to  some  types 
of  bookkeeping  machines  and  are  used  principally  for  depositors'  accounts 
in  banks.  Provision  is  made  for  the  listing  of  the  debits  and  the  credits 
and  the  automatic  recording  of  the  balances,  with  devices  to  call  attention 
to  overdrafts  or  credit  balances. 

Cash  Registers.  Transactions  are  recorded  and  summarized,  and 
in  many  cases  an  analysis  of  the  total  is  made,  through  the  medium  of  this 
machine.  A  recording  device  makes  it  possible  to  obtain  a  list  of  the 
amounts  collected  or  paid.  The  cash  register  serves  as  an  automatic 
check  on  the  amount  of  money  involved  in  the  transactions  recorded. 

Automatic  Money  Changing.  This  device  is  particularly  useful 
where  coins  are  handled.  It  makes  the  computation  and  automatically 
selects  and  delivers  the  coins  required  to  give  exact  change  from  a  larger 
amount. 

Coin  Counting.  Where  it  is  required  to  sort  and  count  coins  of  mis- 
cellaneous denominations,  this  machine  is  invaluable  since  it  performs 
these  operations  automatically.  Some  of  these  machines  have  attach- 
ments which  wrap  coins  automatically  to  make  up  definite  round  sums. 


OFFICE  AND  ACCOUNTING  METHODS  607 

Cheque  Protector.  These  devices  operate  by  perforating  the  amount 
of  the  cheque,  printing  the  amount  of  the  cheque  in  full  on  plain  or  im- 
pregnated paper,  or  shredding  the  paper  over  the  amount  of  the  cheque 
and  the  name  of  the  payee,  the  purpose  being  to  make  it  impossible  to 
make  alterations. 

Time  Recording.  These  machines  make  it  possible  to  have  an  auto- 
matic record  of  the  time  when  the  employee  starts  work  and  finishes  work, 
including  the  time  in  and  out  at  noon  or  after  hours,  either  on  the  job  or 
day  basis. 

Time  Recording  and  Calculating.  A  record  of  the  elapsed  time, 
automatically  excluding  lunch  or  supper  periods,  may  be  obtained  from 
this  type  of  machine.  In  addition  some  machines  have  devices  which 
automatically  calculate  the  wages  to  be  paid,  overhead  to  be  charged,  and 
some  of  the  other  data  required  in  connection  with  the  pay-roll. 

Preparation  of  Money  for  Pay- Rolls.  This  machine  is  invaluable 
as  an  aid  in  putting  up  pay-rolls,  in  that  the  number  of  each  denomination 
of  bills  or  coins  required  to  make  up  each  item  in  the  pay-roll  can  be  as- 
certained automatically  from  the  machine,  which  lists  the  amount  of  each 
item  at  the  same  time.  It  can  also  be  used  to  put  up  coins  to  make  up 
amounts  under  one  dollar. 

Weighing  Machines.  The  ordinary  weighing  machine  has  been 
supplemented  by  a  variety  of  machines  which  compute  automatically 
prices,  etc.,  or  measure  quantities  or  weights  to  be  delivered. 

Clothing  Measuring  Machine.  This  instrument  is  valuable  to 
expedite  the  measuring  of  cloth  and  to  prevent  loss  due  to  inaccuracies. 
The  instrument  is  equipped  with  a  device  for  computing  the  cost  of  the 
goods  measured.    This  makes  it  useful  in  taking  inventories. 

Stamp  Affixer.  By  means  of  this  device  stamps  are  affixed  to  en- 
velopes and  the  number  of  stamps  used  is  registered  in  the  machine. 

Addressing  Machine.  Provides  a  permanent  set  of  plates  or  sten- 
cils from  which  cards,  circulars,  or  letters  in  large  numbers  are  accurately 
addressed  in  a  minimum  of  time.  When  the  addressing  machine  is  used 
to  send  out  dividend  cheques,  customers'  statements,  and  other  financial 
data,  the  auditor  may  use  the  mailing  lists  prepared  from  the  plates  and 
stencils  to  verify  certain  transactions. 

Slide  Rule.  When  there  is  a  series  of  multiplications  or  divisions  to 
be  made  or  a  number  of  percentages  is  required,  the  slide  rule  can  be  used 
to  advantage.  It  may  be  carried  in  the  pocket  and  its  price  is  so  low  as  to 
recommend  it  for  general  use  wherever  computations  are  made. 

Photostat.  By  means  of  this  machine  one  can  obtain  photographic 
copies  of  reports  or  of  any  documents  for  court  or  other  use,  thus  making 


6o8 


AUDITING— GENERAL  PRINCIPLES 


certain  that  no  errors  appear  in  the  copies  submitted.     It  is  usually  quicker 
and  less  expensive  than  are  hand  copies. 

Telautograph.  This  machine  is  used  to  transmit  written  messages. 
It  reproduces  at  the  receiving  end  of  the  wire  a  facsimile  of  the  message 
written  at  the  other  end. 

In  addition  to  those  machines  mentioned,  there  are  many 
other  devices  such  as  cheque-signing  machines,  multigraphs, 
time  stamps,  envelope  sealers,  dictaphones,  dictographs,  number- 
ing machines,  automatic  typewriters,  automatic  letter  openers, 
etc.,  to  which  the  auditor's  attention  is  drawn  from  time  to  time. 
There  are  also  many  registers  or  meters  from  which  data  is  taken 
to  prepare  entries  in  books,  such  as  gas,  electric  and  water 
meters,  cash  fare  registers,  taximeters,  etc. 


Work  Which  May  Be  Done  with  the 

Nature  of  Work 
Cash: 

Receiving  and  disbursing  currency 


Receiving  and  disbursing  cheques 


Preparation  and  verification  of  record 


Notes  Receivable: 

Preparation  and  verification  of  record 


Interest  calculations 


Aid  of  Mechanical  Devices 

Type  of  Machine 

Automatic  money  changing 

Coin  wrapping 

Coin  counting 

Cash  register 

Cheque  protector 

Cheque  signing 

Adding  machine — listing 

Computing 

Numbering 

Telautograph 

Addressograph 

BiUing 

Computing 

Adding  machine — listing 

Billing 

Bookkeeping 

Computing 

Adding  machine — listing 

Computing 

Slide  rule 


OFFICE  AND  ACCOUNTING  METHODS  609 

Type  of  Machine 


Nature  of  Work 
Accounts  Receivable: 
Preparation  and  verification  of  record 


Bookkeeping 

Statement 

Tabulating  and  recording 

Computing 

Adding  machine — listing 

Addressograph 
Stamp  affixing 

Billing 

Bookkeeping 

Computing 

Adding  machine — listing 

Billing 

Bookkeeping 

Tabulating  and  recording 

Computing 

Adding  machine — listing 

Cloth  measuring 

Billing 

Bookkeeping 

Adding  machine — listing 

Computing 
Slide  rule 
Prepaid  Items— Deferred  Charges: 

Preparation  and  verification  of  figures  for     Computing 
rent,  interest,  taxes,  royalties,  unex-     Adding  machine — listing 


Mailing  statements 

Securities: 
Preparation  and  verification  of  record 


Inventories,  Physical  and  Perpetual: 
Preparation  and  verification  of  record 


Plant: 
Preparation  and  verification  of  record 


Calculation  of  depreciation 


pired  insurance  premiums,  etc. 

Notes  Payable: 
Preparation  and  verification  of  record 


Interest  calculations 


Tabulating  and  recording 
Slide  rule 

Billing 

Bookkeeping 

Computing 

Adding  machine — listing 

Computing 
Slide  rule 


VOL.  I — 39 


6io 


AUDITING— GENERAL  PRINCIPLES 

Type  of  Machine 


Nature  of  Work 
Accounts  Payable: 

Preparation  and  verification  of  record  Bookkeeping 

Tabulating  and  recording 
Computing 

Adding  machine — listing 
Accrued  Expenses  and  Liabilities  : 

Preparation  and  verification  of  figures    Computing 
for  rent,  interest,  taxes,  wages,  etc.  Adding  machine — listing 

Tabulating  and  recording 
Slide  rule 


Bonds,  Mortgages  Payable,  etc.: 
Preparation  and  verification  of  record 


Capital  Stock: 
Recording  and  verifying 

Sales: 

Preparation  and  verification  of  record 


Analysis  and  distribution 


Purchases  and  Expenses 
Preparation  of  requisitions 
Examination  of  invoices 


Recording  or  vouchering 
Analysis  and  distribution 


Pay-Rolls: 

Preparation  of  record  of  time 


Billing 

Bookkeeping 

Adding  machine — listing 

Bookkeeping 

Adding  machine — listing 

Billing 
Cash  register 
Numbering 

Computing 

Tabulating  and  recording 

Adding  machine — listing 

Billing 

Computing 

Adding  machine — listing 

Numbering 

Billing 
Bookkeeping 

Computing 

Tabulating  and  recording 

Adding  machine — listing 

Time  recording 
Time    recording    and    cal 
culating 


OFFICE  AND  ACCOUNTING  METHODS 


6ll 


Nature  of  Work 
Preparation  of  roll 


Disbursing 


Analysis  and  distribution 


General: 
Receiving  and  delivering 


Interest  and  discount  calculations 


Preparation  of  stock  record 


Mailing 


Type  of  Machine 
Computing 

Adding  machine — listing 
Billing 
Addressograph 

Preparation  of  money 
Automatic  money  changer 
Coin  counting 

Computing 

Tabulating  and  recording 

Adding  machine — listing 

Weighing 

Computing 

Adding  machine — listing 

Billing 

Computing 

Adding  machine — listing 

Slide  rule 

Billing 

Adding  machine — listing 

Tabulating  and  recording 

Addressograph 
Time  stamp 
Stamp  afiixer 
Envelope  sealers 


Preparation  of  financial  statements  and     Photostats 
statistics,  including  percentages  Computing 

Adding  machine — listing 
Tabulating  and  recording 
Slide  rule 
Multigraph 

Saving  to  Society  by  the  Use  of  Mechanical  Devices. — 
An  examination  to  determine  the  ''saving  to  society"  through 


6l2  AUDITING— GENERAL  PRINCIPLES 

the  use  of  one  of  the  computing  machines,  the  comptometer,  was 
made  recently  by  the  author's  firm.  The  following  quotations 
are  made  from  the  report  on  this  examination : 

While  we  recognize  the  many  shades  of  meaning  applicable  to  both  of 
the  words  ''saving"  and  ''society,"  and  are  well  aware  of  the  possibility  of 
savings  from  which  society  may  receive  no  benefit,  we  have  so  confined  the 
use  of  these  words  in  this  connection  that  a  "saving  to  society"  shall  be 
understood  to  mean  the  avoidance  of  spending  or  losing,  or  the  prevention 
of  waste,  which  make  possible,  at  the  same  total  cost  as  formerly,  greater 
production,  or  broader  distribution,  or  which  reduce  the  cost  of  such  ac- 
tivities, or  in  other  ways  benefit  mankind  as  a  whole. 

A  list  of  them  would  include  actual  saving  in  time;  savings  due  to 
greater  accuracy ;  savings  in  stationery ;  savings  made  possible  as  the  result 
of  the  more  prompt  receipt  by  executives  of  reports  of  one  kind  and 
another;  savings  in  space  and  savings  due  to  the  lower  salaries  demanded 
by  Comptometer  operators,  as  compared  with  mental  calculators.  It 
should  be  borne  in  mind,  however,  that  savings  for  which  the  use  of 
Comptometers  appear  to  be  responsible  are  many  times  largely  attribu- 
table to  a  superior  organization,  without  which  the  value  of  the  instruments 
themselves  would  not  be  so  evident. 

The  results  of  our  interviews  with  forty-nine  owners  of  719  machines 
are  tabulated  as  follows: 

Annual  Saving 
Estimated  Ntmiber      Number       at  an  Assumed 

Saving  for  each  of  of  Comp-  Salary  of 

Comptometer  Owners      tometers      $1,200  per  Clerk 

No  clerks '. .  3  9 

1/2  of  a  clerk 2  4  $     2,400.00 

5/6  of  a  clerk i  18  18,000.00 

I  clerk 15  212  254,400.00 

I  1/2  clerks 5  75  135,000.00 

1  2/3  clerks i  3  6,000.00 

2  clerks 10  167  400,800.00 

2  1/3  clerks i  3  8,400.00 

2  1/2  clerks 2  49  147,000.00 

40  540  $972,000.00 

No  information  available 9  ^79 

49               719 
Average  saving  per  Comptometer $1,800.00 


OFFICE  AND  ACCOUNTING  METHODS  613 

The  test  conducted  by  us  consisted  of  work  of  the  sort  that  occurs  in 
every-day  routine  of  commercial  accounting,  including  such  as  the  com- 
putation in  connection  with  the  preparation  of  a  production  and  stock-on- 
hand  report;  the  calculation  of  percentages;  figuring  tonnage,  inventory 
items  and  discount;  verification  of  freight  way  bills;  footing  and  cross- 
footing.  The  schedule  was  planned  to  keep  an  average  clerk  busy  for  a 
week.  Neither  clerks  nor  operators  understood  that  they  were  doing 
anything  but  some  regular  work. 

In  this  test,  the  average  time  required  by  clerks  was  43  hours,  34  min- 
utes ;  by  Comptometer  operators,  16  hours,  7  minutes — a  net  saving  of  nearly 
I  3/4  clerks  for  each  Comptometer.  In  addition  it  should  be  noted  that 
compared  with  64  errors  made  by  the  operators,  the  clerks  were  guilty  of 
587  errors. 

Useful  Books. — That  familiarity  with  the  types  of  machines 
should  be  supplemented  with  a  knowledge  of  the  books  which 
illustrate  the  many  and  diverse  uses  of  the  machines,  is  brought 
out  in  a  publication  of  the  Western  Society  of  Engineers,  Origin  oj 
Modern  Calculating  Machines^  by  J.  A.  V.  Turck,  from  which  we 
quote : 

A  superficial  examination  of  one  of  the  instruction  books  of  the  "  Comp- 
tometer" will  convince  most  anyone  that  it  is  not  only  the  mechanism  of 
the  machine  that  made  the  modern  calculator  so  valuable  to  the  business 
world,  but  also  the  schemes  laid  down  for  its  use.  Instructions  for  figuring 
multiplication,  subtraction,  division,  square  root,  cube  root,  interest,  ex- 
change, discount,  English  currency,  etc.,  involved  hard  study  to  devise 
such  simple  methods  and  rules. 

The  instruction  books  written  by  Felt  for  the  "Comptometer,  the 
Modern  Calculator,"  reflect  the  genius  disclosed  in  the  invention  of  the 
machine  itself. 

Filing  Systems 

With  the  unit  system  of  records  has  come  the  unit  system  of 
filing.  Press  copy  books  are  becoming  a  rarity  and  have  been 
discarded  by  most  modern  offices.  Documents,  correspondence, 
etc.,  are  now  filed  in  vertical  files  and  in  readily  accessible  form. 

Some  modern  offices  retain  the  old  system  of  making  a  carbon 
copy  of  each  letter.     In  the  mailing  department  a  press  copy  is 


6l4  AUDITING— GENERAL  PRINCIPLES 

also  made  in  a  letter  book.  The  carbon  copy  takes  the  place  of  a 
*' tickler"  and  is  filed  so  that  it  comes  up  for  further  attention  on 
the  day  decided  upon.  The  letter  book  impression  is  taken  just 
before  the  letter  is  put  in  the  envelope.  It  records  the  signatures 
and  other  identifying  marks.  It  is  properly  indexed,  and  be- 
comes an  additional  safeguard  in  case  of  the  loss  of  the  carbon 
copy  or  the  unwarranted  alteration  of  the  letter. 

Essential  Features. — The  essential  features  of  a  good  filing 
system  are: 

1 .  Certainty  of  obtaining  any  paper  or  all  papers  on  a  partic- 

ular subject. 

2.  Rapidity  of  obtaining  filed  papers. 

3.  Rapidity  of  filing  papers. 

4.  Cheapness  of  operation. 

5.  Simplicity. 

6.  Small  space  required. 

7.  Cross-reference,  numbering,  etc. 

Report  of  Commission  on  Economy  and  Efficiency. — In 
a  report  on  the  handling  and  filing  of  correspondence,  ex- 
President  Taft's  Commission  on  Economy  and  Efficiency  made 
the  following  suggestions.  These  apply  with  as  great  force  to 
the  average  business  corporation  as  to  the  government  service. 

1.  That  all  correspondence  shall  be  filed  flat  in  vertical  files. 

2.  That  all  correspondence  should  be  filed  by  subjects  arranged  upon 
a  self-indexing  basis. 

3.  No  book  or  card  record  of  correspondence  is  desirable. 

4.  That  carbon  copies  should  supplant  press  copying. 

5.  That  the  employment  of  the  dictation  machine  (phonograph)  for 
dictating  should  be  extended  widely. 

6.  That  transparency  or  "window"  envelopes  should  be  used. 

7.  That  forms  that  must  be  filled  in  on  the  typewriter  should  be  so 
arranged  as  to  facilitate  the  work. 

8.  That  on  internal  correspondence  no  salutation  or  compHmentary 
closing  should  be  used  and  that  the  initials  of  the  person  addressed  and  the 
writer  should  be  used  instead  of  full  names. 


OFFICE  AND  ACCOUNTING  METHODS  615 

Copying 

If  many  copies  are  desired,  the  multigraph,  the  revolving 
duplicator,  or  the  old-fashioned  flat  duplicator  may  be  used. 
The  revolving  duplicator  is  perhaps  most  popular,  because  it 
requires  only  the  typewriting  of  a  waxed-paper  stencil.  For 
work  requiring  more  than  a  thousand  impressions,  the  multi- 
graph  or  one  of  the  several  makes  of  printing  machines  is 
preferable.  When  exact  copies  are  required,  or  when  only  a 
few  copies  are  desired,  photostatic  copies  are  the  most  satis- 
factory. 

Mailing  Department 

The  handling  of  mail  is  important  and  usually  constitutes  a 
separate  department.  Incoming  mail  usually  contains  remit- 
tances in  cheques  and  cash,  and  has  proven  more  than  once  a 
simple  source  of  illegitimate  wealth  to  enterprising  but  ill-paid 
clerks  and  cashiers.  Some  responsible  person — ^preferably  an 
officer  of  the  company — should  have  charge  of  the  incoming  mail. 
As  it  is  opened  it  should  be  distributed  to  baskets  designated  for 
the  various  departments,  and  should  be  delivered  with  as  much 
care  as  is  used  in  opening  it. 

Outgoing  mail  must  be  handled  differently.  The  stenog- 
raphers who  write  letters  should  address  the  envelopes  at  the 
same  time;  then,  instead  of  both  being  delivered  to  the  executive, 
the  letter  only  should  be  delivered,  while  the  envelope  (together 
with  any  inclosures)  should  be  sent  to  the  mailing  department. 
When  the  letter  has  been  signed  it  is  sent  to  the  mailing  depart- 
ment, where  it  is  put  in  the  envelope,  with  the  inclosures,  and 
is  sealed,  stamped,  and  mailed.  It  is  the  duty  of  the  mailing 
department  to  keep  posted  on  changes  in  closing  hours  for  the 
various  domestic  and  foreign  mails. 

Stock  on  Hand 

In  many  cases  the  auditor  finds  it  practicable  to  introduce 
a  perpetual  inventory  of  stock  on  hand.    He  may  base  his 


6l6  AUDITING— GENERAL  PRINCIPLES 

suggestions  on  the  following  general  recommendations  quoted 
from  The  Accountant'' s  Manual,  Vol.  II: 

1.  Debit  and  credit  accounts  should  be  opened,  as  far  as  possible,  for 
each  description  of  stores  used.  On  one  side  of  the  accounts  the  receipts 
would  be  entered,  showing  the  date,  weight,  quantity,  or  number,  and 
other  particulars ;  and,  on  the  other  side,  the  stores  issued  from  time  to  time 
would  be  entered,  with  such  particulars  as  were  necessary  or  suitable,  the 
diflference  representing  what  ought  to  be  in  hand,  or  thereabouts,  as,  in 
accounts  of  this  kind,  the  balance  shown  upon  the  accounts  can  hardly  be 
depended  upon  exactly. 

2.  It  is  the  opinion  of  practical  mill  owners  and  managers  that  in  many 
cases  a  really  efficient  and  exact  check  on  stores  is  not  practicable.  It 
could,  no  doubt,  be  devised,  but  the  detailed  work  in  connection  with  it, 
and  consequent  labor  and  expense,  put  it  out  of  the  range  of  every-day 
business,  whatever  theorists  may  say.  But  many  useful  rules  may  be  laid 
down  preventive  of  fraud  and  waste,  amongst  others  the  following,  taken 
from  actual  experience: 

(a)  Where  stores  are  distributed  for  use  upon  a  specific  job,  the  job 
should  be  stated,  with  the  weight,  quantity,  etc. 

(b)  If  material  of  the  same  kind  is  distributed  to  various  men  for  the 
same  purpose,  a  comparison  should  be  made  between  the  results  produced 
by  each.  If  discrepancies  are  found,  inquiries  should  be  made,  and  doubt- 
less in  some  cases  a  good  explanation  could  be  given:  e.  g.,  use  of  old  ma- 
chinery or  appliances,  etc. 

(c)  The  storeroom  should  be  situated  in  a  convenient  place,  and  be  in 
charge  of  a  competent  man  who  combines  practical  knowledge  of  the  stores 
with  sufficient  bookkeeping  experience  to  appreciate  the  importance  of 
account  keeping. 

(d)  The  principal,  or  manager,  should  make  a  point  of  examining  at 
times  the  stock  ledgers  and  exercising  general  supervision  of  the  depart- 
ment. Frequent  and  unnotified  visits  should  be  made,  and  the  store- 
keeper, if  possible  (it  is  not  always  possible),  changed  (occasionally). 

(e)  Some  kinds  of  stores  should  never  be  given  out  unless  the  used-up 
stores  are  returned.  For  example,  a  workman  making  requisitions  for 
files,  brushes,  and  like  things,  should  be  supplied  only  on  his  giving  up  the 
old  articles.  This  is  a  very  good  check  when  the  nature  of  the  stores  will 
allow  of  its  application. 

Stock  Records. — Stock  accounts  should  show  quantity  as 
well  as  value,  since  one  forms  a  good  check  upon  the  other. 


OFFICE  AND  ACCOUNTING  METHODS  617 

The  forms  used  should  provide  for  an  opening  balance  or 
inventory,  to  which  should  be  added  daily  the  quantity  and 
value  of  the  material  purchased  or  manufactured.  Provision 
should  be  made  for  totaling  these  debits  and  for  deducting  there- 
from the  quantity  sold  and  its  cost  value.  The  balance  should 
agree  with  an  actual  inventory. 

A  more  detailed  form  used  by  many  concerns  provides 
columns  to  show  not  only  the  balance  and  purchases  daily,  but 
also  the  sales  and  the  new  balance.  Noted  at  the  top  of  the  sheet 
or  card  is  the  minimum  quantity  of  stock  to  be  carried,  as  well  as 
the  maximum  quantity.  At  certain  times  when  the  stock  reaches 
a  low  point,  the  records  are  checked  by  comparison  with  an  actual 
inventory.  As  a  consequence  the  taking  of  inventory  is  not  left 
until  the  end  of  the  period,  but  is  performed  continuously. 

Business  is  so  varied  in  its  nature  that  some  lines  do  not  per- 
mit of  a  regular  system  of  stock  accounts — nor  is  it  especially 
necessary  in  some  cases,  such  as,  for  example,  traders  dealing  in 
small  articles  broken  from  bulk.  While  different  methods  of 
check  must  be  employed  in  such  cases,  there  are  some  general 
forms  which  may  be  adopted  and  which  will  be  found  practicable 
for  ordinary  lines  of  business. 

Stock  Records  at  Sales  Prices. — Every  trade  is  supposed 
to  earn  a  certain  percentage  of  gross  profit,  which  should  be  based 
on  a  *'  mark  up  "  from  cost,  not  on  the  selling  price.  If,  therefore, 
a  stock  account  is  started  with  the  actual  stock  on  hand  valued 
at  the  purchase  price,  and  there  are  added  to  it  from  time  to  time 
(say  monthly),  the  total  cost  of  purchases,  and  also  the  estimated 
gross  profits  referred  to,  this  amount,  less  the  total  sales,  should 
show  the  stock  on  hand,  assuming  that  the  gross  profit  named 
has  been  exactly  earned.  By  deducting  the  gross  profit  from  the 
sales  and  then  crediting  the  stock  account,  the  same  result  would 
be  secured.  This  book  figure  can  easily  be  verified  or  corrected 
at  the  time  of  actual  inventory. 

If  a  more  accurate  check  on  the  various  departments  is 


6l8  AUDITING—GENERAL  PRINCIPLES 

desired,  the  following  method  is  employed:  All  goods  are  charged 
to  departments  at  selling  price,  this  having  been  determined 
in  advance.  Any  changes  in  value  are  recorded  and  when  the 
inventory  is  taken  it  is  priced  at  cost,  for  the  private  office,  and 
also  at  selling  price,  for  the  purpose  of  verification;  so  the  account 
should  balance  exactly.  Houses  whose  business  reaches  a  large 
volume  find  that  this  system  gives  satisfactory  results  with  but 
slight  discrepancies.  It  can  be  extended,  too,  with  advantage  to 
other  trades,  such  as  retail  branch  stores  selling  cigars,  groceries, 
men's  furnishing  goods,  and  similar  lines. 

Testing  Records. — Another  common  and  often  useful  prac- 
tice in  testing  the  accuracy  of  the  stock  count  at  any  time  is  to 
make  a  comparison  between  the  stock  and  sales  for  a  particular 
period  and  a  corresponding  period  in  prior  years.  This,  however, 
is  only  a  rough  test  and  not  a  definite  one. 

The  accounts  of  an  estabhshment  which  handles  various 
kinds  of  goods  should  be  so  kept  that  the  position  of  the  various 
departments  as  to  purchases,  sales,  etc.,  may  readily  be  learned. 
Such  a  system  serves  two  very  useful  purposes:  (i)  Attention  is 
directed  to  any  discrepancy  between  actual  and  estimated  gross 
profits  by  a  corresponding  difference  between  physical  and  book 
inventories.  (2)  Needed  information  is  furnished  from  month 
to  month  as  to  the  probable  amount  of  stock  in  each  department. 
This  knowledge  serves  as  a  guide  to,  and  check  upon,  the  various 
departmental  managers;  it  also  affords  material  for  an  interim 
balance  sheet,  if  one  is  desired. 

Gross  Profits  in  Various  Lines. — To  furnish  conclusive 
information  relative  to  gross  profits  made  in  various  retail  lines 
is,  of  course,  impossible.  Situation,  nature  of  the  business, 
poHcy  of  the  management,  local  conditions — all  enter  into  the 
result,  so  that  any  attempt  to  outline  even  approximate  figures 
would  be  unwise  and  misleading.  However,  any  auditor  can 
compile  a  table  out  of  his  own  experience  which  should  prove 
useful. 


OFFICE  AND  ACCOUNTING  METHODS  619 

Designing  Stock  Accounts. — If  it  becomes  necessary  for  the 
auditor  to  design  stock  accounts  for  any  particular  business,  he 
should  take  advantage  of  whatever  practical  experience  his 
clients  or  their  managers  possess,  and  should  supplement  such 
knowledge  by  his  own  experience.  If  he  is  so  fortunate  as  to  have 
an  intimate  acquaintance  with  the  business  in  hand,  he  will 
undoubtedly  find  this  knowledge  of  very  great  assistance. 

Controlling  Subsidiary  Ledgers 

In  nearly  every  concern  the  individual  bookkeepers  have 
adopted  some  device  for  balancing  their  ledgers.  This  is  usually 
in  the  form  of  a  large  ^' proof-sheet, '^  on  which  are  recorded  the 
totals  of  the  various  books  or  columns  from  which  the  details 
were  posted.  Where  there  are  a  number  of  ledgers,  each  depend- 
ent upon  all  the  others  for  its  balance,  even  such  a  makeshift 
is  helpful  in  locating  the  ledger  that  is  out  of  balance. 

But  a  much  more  practical  and  scientific  plan  is  to  employ 
in  the  general  ledger  a  controlling  account  for  each  subsidiary 
ledger.  From  the  various  books  of  original  record  the  details  are 
posted  to  the  subsidiary  ledgers,  but  the  totals  are  posted  to  the 
respective  controlling  accounts  in  the  general  ledger,  thus  keeping 
that  ledger  in  balance.  For  instance,  there  may  be  two  sales 
ledgers  (A-M  and  N-Z)  to  which  the  details  of  the  sales  book  are 
posted.  In  the  general  ledger,  *' sales"  account  is  credited  as 
usual,  but  in  addition  each  of  the  sales  ledger  controlling  accounts 
is  debited  with  its  part  of  the  total  sales. 

Ledger  A-M  Controlling  Account $ 

Ledger  N-Z  Controlling  Account 

To  Sales  Account $ 

Columnar  Ledgers 

Another  form  of  ledger,  to  which  the  term  "self-balancing"  is 
also  applicable,  is  the  columnar  ledger.  Its  advantage  is  that  a 
large  number  of  customers  or  accounts  can  be  carried  in  a  com- 
paratively small  space  and  can  be  referred  to  with  a  minimum  of 


620  AUDITING— GENERAL  PRINCIPLES 

effort.  It  can  be  used,  however,  only  when  the  number  of  trans^ 
actions  with  each  customer  is  small.  It  has  not  been  found  in 
practice  to  be  well  adapted  to  manufacturing  and  mercantile 
businesses  and  its  use  has  been  discontinued  by  many  concerns 
which  formerly  used  it. 

The  ledger  provides  a  line  or  a  double  line  for  each  account 
and  columns  for  receiving  debits  and  credits  which  are  posted 
once  each  month,  or  at  other  intervals.  The  totals  in  each  column 
are  carried  forward  from  page  to  page  or  are  recapitulated,  and 
the  final  totals  should  agree  with  the  totals  in  the  controlling 
accounts  in  the  general  ledger. 

Another  use  of  the  tabular  ledger  is  as  a  summary  of  charges 
where  customers  have  a  very  large  number  of  transactions 
monthly.  The  details  are  kept  in  a  subsidiary  ledger  and  are 
posted  in  total  to  the  tabular  ledger.  It  then  becomes  a  ledger  of 
controlling  accounts,  and  is  in  turn  controlled  by  an  account  in  the 
general  ledger. 

Efficiency  of  Organization 

An  auditor  is  peculiarly  fitted,  upon  the  completion  of  an  audit, 
to  comment  intelligently  upon  the  efficiency  of  the  organization. 
He  has  had  access  to  all  the  records  and  has  seen  the  performance 
of  the  staff  under  various  conditions.  The  average  client  today 
wants  suggestions  relative  to  the  perfection  of  his  organization, 
and  he  should  have  them.  The  auditor  should  be  able  to  judge 
whether  the  staff  is  too  large,  whether  the  arrangement  of  the 
office  and  the  layout  of  the  work  are  capable  of  improvement,  and 
whether  there  is  needless  repetition  of  records  in  any  department. 

Many  times  it  is  possible  to  show  laziness  or  inability  on  the 
part  of  employees,  by  applying  the  efficiency  theory  that  for 
any  task  there  is  a  determinable  standard. 


CHAPTER  XXVIII 
DEPRECIATION 

Due  to  the  modern  development  of  business  and  industry  and 
the  enormous  additions  to  the  value  of  property ,  plant  appliances, 
and  stock-in-trade,  and  particularly  since  the  incidence  of  high 
tax  rates  in  191 7,  the  question  of  depreciation  or  allowance  for 
loss  of  value  has  gained  much  in  importance. 

Indeed,  the  determination  of  proper  allowances  for  depreci- 
ation is  one  of  the  most  important  which  accountants  are  called 
upon  to  discuss.  The  auditor  must  always  consider  the  ade- 
quacy or  inadequacy  of  the  provision  made,  before  he  can 
determine  the  form  of  the  certificate  or  report  which  he  can 
present. 

It  is  important  at  the  outset  to  distinguish  between 
fluctuation  and  depreciation.  The  former  is  attributable  to 
causes  outside  the  business  itself  and  may  be  a  change  for  better 
or  worse  in  the  value  of  the  assets.  Entirely  extraneous  in- 
fluences may  cause  fluctuation  in  the  value  of  assets.  Therefore 
it  is  generally  admitted  that  since  the  actual  manufacturing 
profits  are  not  affected  thereby  one  way  or  the  other,  these 
fluctuations  in  value  should  not  be  considered  in  the  current 
accounts. 

Depreciation,  however,  is  a  decline  in  the  value  of  property 
which  is  certain  to  occur  as  a  result  of  wear  and  tear  and  gradual 
obsolescence.  It  is  due  to  the  possession  and  use  of  the  assets, 
and  therefore  is  a  part  of  the  cost  of  operation.  A  concise 
definition  of  depreciation  which  has  been  widely  used  is  that  it  is 
the  deterioration  of  anything  by  time  or  use.  P.  D.  Leake's 
definition,  "  expired  outlay  upon  productive  plant,"  is  a  good  one, 
as  is  also  ''accrued  renewals." 

Before  leaving  the  subject  of  fluctuation,  however,  it  may  be 

621 


622  AUDITING— GENERAL  PRINCIPLES 

well  to  consider  what  treatment,  if  any,  a  favorable  fluctuation  in 
the  value  of  fixed  assets  and  current  assets  should  receive.  As  to 
fixed  assets,  it  is  generally  conceded  that  the  increase  should 
be  treated  as  a  secret  reserve.  As  to  current  assets,  there  is, 
temporarily,  a  secret  reserve  which  is  included  in  trading  profits 
when  the  assets  affected  are  realized.  An  unfavorable  fluctuation, 
if  apparently  of  a  temporary  character,  may  be  disregarded;  but 
when  it  is  probable  that  the  unfavorable  conditions  will  remain 
until  the  time  of  realization  of  the  assets  affected,  provision 
should  be  made  for  the  loss.  In  other  words,  an  unfavorable 
■fluctuation  should  be  charged  against  the  period  in  which  it 
occurs  (as  an  extraordinary  item),  not  against  the  period  of 
realization. 

In  general,  it  is  not  necessary  from  a  legal  standpoint  to  charge 
an  unfavorable  fluctuation  in  fixed  assets  against  income  before  the 
declaration  of  dividends  from  current  net  income.  While  these 
fluctuations  may  be  disregarded  in  accounts,  it  may  be  desirable, 
however,  to  present  the  true  state  of  affairs  to  stockholders  by 
means  of  a  note  attached  to  the  balance  sheet  or  included  in  the 
auditor's  report. 

The  New  York  Court  of  Appeals,  in  one  of  its  decisions,' 
stated  the  theory  of  depreciation  reserves  in  a  most  lucid  manner 
as  follows: 

Judicial  notice  may  be  taken  of  the  fact  that  in  the  conduct  of  many 
industrial  enterprises  there  is  a  constant  deterioration  of  the  plant  which 
is  not  made  good  by  ordinary  repairs  and  which,  of  course,  operates  con- 
tinually to  lessen  the  value  of  the  tangible  property  which  it  affects.  The 
amount  of  this  depreciation  differs  in  different  enterprises,  but  the  annual 
rate  is  usually  capable  of  estimate  and  proof  by  skilled  witnesses.  No 
corporation  would  be  regarded  as  well  conducted  which  did  not  make 
some  provision  for  the  necessity  of  ultimately  replacing  the  property  thus 
suffering  deterioration;  and  we  cannot  see  why  an  allowance  for  this  pur- 
pose should  not  be  made  out  of  the  gross  earnings  in  order  to  ascertain  the 
true  earning  capacity. 


^People  ex  rel.  Jamaica  Water  Supply  Company  v.  State  Board  of  Tax 
Commissioners,  196  N.  Y.  39. 


DEPRECIATION  623 

Although  the  charge  for  depreciation  is  recognized  by  the  law, 
and  provision  is  made  therefor  in  the  forms  supplied  by  the 
Treasury  Department  in  connection  with  the  federal  income  tax 
law,  there  is  a  wide  difference  of  opinion  as  to  the  amount  of  the 
allowance  to  be  made  from  time  to  time.  Many  company 
officials  prefer  to  regard  depreciation  charges  as  flexible.  They 
adjust  them  to  meet  the  conditions  of  different  years,  so  that 
in  time  of  large  profits  the  allowance  shall  be  large,  and  during 
bad  years  the  allowance  small,  or  none. 

This,  however,  is  entirely  opposed  to  sound  accounting 
principles,  and  the  Treasury  Department  here  agrees  with  the 
opinion  of  the  accounting  profession.  It  is  important  that  there 
should  be  some  fixity  in  regard  to  the  rate  of  depreciation  to  be 
allowed.  Under  the  system  of  varying  charges  for  depreciation  it 
is  impossible  to  fix  an  intelligent  basis  of  rates,  and  comparisons 
with  other  years  are  practically  worthless.  If  the  business  man, 
whether  in  the  railroad  world  or  elsewhere,  passes  over  one  year 
without  making  any  allowance  for  depreciation,  it  results  in  a 
misrepresentation  of  conditions  at  the  end  of  that  year,  and  it  is 
imjust  and  incorrect  in  everyway  to  expect  a  good  year  to  bear  the 
burden  of  depreciation  which  has  occurred  in  one  or  more  bad  years. 

In  the  administration  of  the  income  tax  laws  some  tax  in- 
spectors have  taken  an  attitude,  prejudicial  to  good  accounting 
practice,  by  insisting  on  the  reduction  of  reserves  to  insufiicient 
amounts.  These  incorrect  views,  however,  have  rarely  been 
sustained  by  Treasury  officials.  ^ 

When  Fixed  Rates  Are  Not  Applicable. — The  fixed  rates 
referred  to  in  the  preceding  discussion  are  based  on  normal  wear 
and  tear.  When  machinery  is  worked  overtime,  or  when  labor 
conditions  make  it  difficult  to  secure  and  retain  efficient  forces, 
it  is  necessary  to  increase  the  normal  rates.  The  Treasury 
Department  has  recognized  this  principle.^    Obviously  no  rule 


^See  Montgomery,  Income  Tax  Procedure,  192 1,  pages  839-840. 
3  See  Income  Tax  Procedure ^  1921,  page  703  et  seg. 


624  AUDITING— GENERAL  PRINCIPLES 

can  be  laid  down  to  fix  the  increases;  as  the  causes  are  special,  the 
rates  vary  correspondingly. 

Causes  of  Depreciation 

The  various  classes  of  depreciation  have  been  very  clearly 
described  by  Professor  M.  E.  Cooley: 

1.  Depreciation  Due  to  Wear  and  Tear  and  Exposure  to  the 
Elements.  This  is  continuous.  All  elements  have  a  wearing  Hfe  varying 
with  the  element  itself.  No  element  can  be  completely  worn  out ;  it  can  be 
worn  only  to  a  point  below  which  it  becomes  unsafe  or  no  longer  serves  its 
original  function.  In  practice  the  average  condition  of  all  elements  must 
be  maintained  at  a  high  percentage  of  the  original  cost  if  the  property  is  to 
serve  its  purpose  properly.  This  percentage  varies  from  75  per  cent  to  85 
per  cent  of  the  cost  new  of  the  property.  The  difference  between  this  per- 
centage of  from  75  to  85  and  the  original  100  is  a  depreciation  which  is 
inherent  in  the  property  and  cannot  be  dispensed  with.  It  must  be  met  by 
a  sinking  fund,  or  its  equivalent,  otherwise  this  part  of  the  original  invest- 
ment becomes  lost. 

2.  Depreciation  Due  to  Accidents;  a  Sudden  Depreciation.  An 
engine  or  a  boiler  may  be  wrecked,  and  with  it,  other  machinery.  This 
might,  and  probably  would,  involve  a  considerable  expense  for  repairs 
or  replacement  besides  possibly  crippling  the  plant  in  part.  Cars  may 
collide  or  a  car  may  drop  through  a  bridge.  A  bridge  itself  may  fall  or  be 
carried  away  by  floods.  A  storm,  as  a  cyclone,  may  work  havoc,  entailing 
costs  in  excess  of  those  proper  to  be  charged  to  ordinary  maintenance  of 
property. 

3.  Depreciation  Due  TO  Inadequacy.  Cars  suitable  in  the  past  have 
already  been  superseded  several  times  by  larger  and  better  cars.  This 
has  rendered  the  track,  structure,  and  bridges  inadequate,  and  as  more 
power  is  required  to  propel  the  larger  cars,  the  power  plants  have  become 
inadequate.  The  public  demand  is  largely  responsible  for  this  depreciation 
due  to  inadequacy. 

4.  Depreciation  Due  to  Obsolescence.  This,  while  closely  allied  to 
the  depreciation  due  to  inadequacy,  is  different  in  that  it  embraces  changes 
due  to  advance  in  the  art.  More  efficient  and  effective  machinery  has 
appeared  which  must  be  substituted  for  the  old  to  keep  abreast  of  the  times. 
For  example,  in  steam-engine  practice  the  turbine  has  come  into  general 
use  during  the  past  five  years  and  the  art  of  steam  turbines  is  at  the  be- 
ginning.   Generators  adapted  to  piston-engine  practice  are  not  adapted 


DEPRECIATION  625 

to  steam-turbine  practice  and  must  also  be  changed.  Boilers  adapted  to 
piston-engine  practice  must  be  replaced  to  carry  the  higher  pressures 
required.  Condensers  must  also  be  changed  to  secure  the  better  vacuum 
required  to  realize  the  full  advantage  of  the  steam  turbine.  Owing  to  the 
rapid  disappearance  of  coal  beds,  the  price  of  fuel  must  advance,  and  this 
presumably  will  before  many  years  force  the  adoption  of  the  gas  producer 
and  the  producer  gas  engine.  Water  powers  are  wisely  being  developed ,  but 
to  utilize  them  requires  the  scrapping  of  large  parts  of  the  machinery  in  use 
at  present. 

Repairs  and  Maintenance 

It  is  an  accepted  rule  that  repairs  and  all  other  expenses  of 
maintenance  should  be  charged  against  income.  An  exception 
is  found  to  this  rule  in  cases  where  partially  worn-out  or  run-down 
plants  are  purchased  with  the  intention  on  the  part  of  the  new 
owners  to  rehabiHtate  them  so  that  they  can  be  operated 
efficiently.  It  may  be  assumed  that  the  purchase  price  takes  the 
poor  condition  of  the  plant  into  consideration,  in  which  case 
the  entire  cost  of  the  repairs  and  renewals  necessary  to  rehabili- 
tate the  plant  may  properly  be  capitalized. 

The  auditor  should  not  decide  on  the  amount  required  for 
depreciation  until  he  has  scrutinized  the  repairs  account,  since  in 
this  account  he  may  find  that  charges  have  been  made  for  re- 
newals and  replacements  which,  so  far  as  they  go,  apply  in  lieu  of 
a  depreciation  reserve.  "* 

If  a  machine  could  be  built  like  the  *'one-hoss  shay,"  this 
question  would  not  arise  and  a  depreciation  reserve  would  work 
out  exactly,  but  imder  modern  conditions  it  invariably  happens 
that  a  machine  wears  out  one  part  at  a  time,  and  if  the  parts  are 
replaceable,  the  life  of  the  machine  as  a  whole  may  be  extended 
almost  indefinitely.  Obsolescence  and  inadequacy  are  the 
practical  factors  which  operate  against  a  fair  test  of  the  possible 
life  of  present-day  plant  and  equipment. 

Henry  Floy,  the  eminent  engineer,  cites  the  following  instance: 


'♦For  a  discussion  of  the  relation  of  depreciation  to  repairs  see  Mont- 
gomery, Income  Tax  Procedure,  192 1,  pages  844-847. 
VOL. I — 40 


626 


AUDITING— GENERAL  PRINCIPLES 


For  example,  the  life  of  the  ordinary  steam  engine  may  be  taken  at 
twenty  years,  but  it  is  not  uncommon  to  find  engines  still  in  use  that  are 
very  much  older  than  this.  The  writer  noted,  within  a  few  months,  that  a 
vertical  engine  installed  in  England  in  1856  had  recently  been  equipped 
with  condenser,  supplied  with  superheated  steam,  and  was  still  in  use  at 
fifty-five  years  of  age,  giving  economical  and  satisfactory  results. 

Methods  of  Applying  Depreciation  in  the  Books 

The  following  table  shows  the  results  of  different  methods 
of  calculating  depreciation  ^  over  a  period  of  ten  years  upon  an 
article  costing  $1,000  with  a  break-up  value  of  $100  at  the  close 
of  the  decade: 


Year 

Fixed  percentage 

Method.    10%  of 

Total  Depreciation 

Fixed  Percentage 

Method.  20.57%* 

on  Diminishing 

Value 

Sinking  Fund 

Method.    At  5% 

Compound 

Interest 

I 

$90.00 

$205.70 

$71.55 

2 

90.00 

163.38 

71.55 

3 

90.00 

129.78 

71.55 

4 

90.00 

103.08 

71.55 

5 

90.00 

81.88 

71.55 

6 

90.00 

65.03 

71.55 

7 

90.00 

51.66 

71.55 

8 

90.00 

41.03 

71.55 

9 

90.00 

32.59 

71.55 

10 

90.00 

25.87 

71.55 

$715.50 

Compound     In- 

terest at  5% 

184.50 

Totals 

$900.00 

$900.00 

$900.00 

*20.S7%  =  ioo   [i-(^)   ^] 


s  =  $100  scrap  or  residual  value 

a  =  $1,000  or  original  value 

n  =  10  years  or  nvimber  of  periods 


sFor  United  States  Treasury  rulings  on  methods,  see  Montgomery,  In- 
come Tax  Procedure,  1921,  pp.  858-859. 


DEPRECIATION  627 

I.  The  Fixed  Percentage  Basis. — This  method  is  the  most 
popular  and  is  the  one  in  general  use.     It  is  applied  as  follows: 

(a)  On  a  flat  basis,  e.g.,  if  the  life  of  a  machine  is  ten  years, 

one- tenth,  or  10  per  cent  of  the  cost  less  estimated 
scrap  value  is  charged  off  annually. 

(b)  On  a  reducing  scale  basis,  i.e.,  a  rate  is  ascertained 

which,  when  applied  to  the  original  cost  and  on  the 
diminished  value  thereof  as  periodically  determined, 
will  reduce  the  book  value  to  scrap  value  at  the  end  of 
its  estimated  life. 

Method  (a)  is  more  generally  followed  than  (b),  although 
there  is  in  use  a  method  which  is  a  cross  between  the  two  and 
which  is  not  scientific.  It  consists  in  charging  the  rate  as  deter- 
mined under  (a),  but  in  applying  it  to  the  reducing  value  instead 
of  to  the  original  cost.  For  instance,  if  the  life  of  a  boiler  is 
estimated  at  ten  years,  10  per  cent  per  annum  is  set  aside,  but 
on  the  diminishing  value.  If  the  table  on  page  626  were 
calculated  on  this  basis,  the  book  value  would  be  $348.68  at 
the  end  of  the  tenth  year,  instead  of  $100  as  under  the  other 
methods. 

Nevertheless,  this  is  a  popular  method  and  must  be  reckoned 
with.  The  fact  of  the  matter  is  that  when  an  executive  directs 
a  clerk  to  *' charge  off  10  per  cent  for  depreciation,"  he  does  not 
stop  to  consider  whether  it  means  of  the  original  cost  or  the 
reduced  value.  • 

The  theory  of  and  advantage  claimed  for  (b)  is  that  repairs 
and  maintenance  are  very  light  during  the  early  years  of  a 
machine  and  very  heavy  during  the  later  years.  In  both  (a) 
and  (b)  it  is  contemplated  that  all  maintenance  costs  are  to  be 
charged  off  in  addition  to  the  depreciation. 

Roughly  speaking,  with  (b)  the  aggregate  of  depreciation  and 
maintenance  is  the  same  each  year,  whereas  under  (a)  the 
aggregate  during  the  first  years  is  light  and  during  the  last 
years  heavy. 


628  AUDITING— GENERAL  PRINCIPLES 

2.  Sinking  Fund  Method. — If  it  is  proposed  to  set  aside 
such  a  sum  periodically  as  will  equal  the  original  cost  of  a  machine 
(less  scrap  value)  at  the  end  of  its  estimated  Hfe,  it  is  customary, 
after  taking  into  consideration  the  average  rate  of  interest  which 
can  be  secured,  to  pay  into  a  fund  a  fixed  amount  periodically. 
The  aggregate  thereof,  together  with  the  accumulated  interest, 
equals  the  amount  required  to  renew  the  machine  in  question. 
This  method  is  seldom  followed.  There  is  good  authority,  how- 
ever, for  its  use  where  a  single  large  piece  of  property  is  being 
operated. 

This  point  is  well  expressed  by  Mr.  Floy: 

In  all  cases  involving  a  consideration  of  the  expenses  of  keeping  a 
property  in  operation,  there  should  invariably  be  included  allowances  to 
cover  all  ultimate  depreciation  and  replacement.  For  a  small  company 
or  where  relatively  large  proportions  of  the  invested  capital  are  locked 
up  in  a  few  or  single  pieces  of  property,  it  is  preferable  to  accumulate, 
in  advance  out  of  operating  income,  reserve  funds  from  which  to  provide 
for  all  classes  of  depreciation.  But  such  method  may  be  unnecessary  and 
possibly  an  inexpedient  accounting  complexity  with  large  corporations, 
where  the  investments  in  any  single  piece  of  physical  property  are  small, 
relative  to  the  total  investment.  The  truth  of  the  above  will  be  at  once 
recognized  from  the  following  illustration.  If  the  company  which  erected 
the  Metropolitan  Life  Insurance  building  had  only  that  property,  it  would 
be  essential  that  funds  should  be  laid  aside  annually  in  amounts  sufficient 
to  replace  the  original  investment  at  the  end  of  the  useful  life  of  said 
building. 

The  conflict  between  'the  Third  Avenue  Railway  Company 
and  the  New  York  Public  Service  Commission  with  reference  to 
the  actual  setting  aside  of  an  amortization  fund  and  a  depreci- 
ation fund  is  of  considerable  interest.  The  Third  Avenue  Rail- 
way Company  had  gone  through  a  receivership  and  the  par 
value  of  the  securities  of  the  reorganized  company  exceeded  by  a 
considerable  amount  the  value  of  the  physical  property  owned  by 
the  company.  The  commission  directed  that  a  fund  be  created 
into  which  the  company  should  pay  annual  instalments  out  of  its 
income,  so  that  at  maturity  of  the  outstanding  securities  an 


DEPRECIATION  629 

amount  would  have  been  accumulated  which,  together  with  the 
company's  other  property,  would  equal  the  par  value  of  the 
outstanding  securities. 

The  commission  also  directed  that  there  be  set  aside  annually 
at  least  20  per  cent  of  the  earnings  for  current  maintenance  and 
future  replacements  (depreciation),  the  unexpended  portion  of 
this  amount  to  be  "credited"  to  a  separate  depreciation  fund  at 
the  end  of  each  year. 

The  opinion  of  the  commission  is  of  sufficient  importance  and 
interest  to  warrant  the  reproduction  in  full  of  that  part  dealing 
particularly  with  the  amortization  and  depreciation  funds. 

Amortization  of  Discounts.  The  requirement  that  discounts  shall 
be  amortized  is  a  generally  recognized  principle.  The  unanimous  con- 
clusion of  the  Railroad  Securities  Commission  in  its  recent  report  to  the 
President  of  the  United  States  was  to  this  effect :  "  It  seems  to  be  generally 
agreed  that  no  limitation  should  be  placed  on  the  price  at  which  bonds  can 
be  sold,  but  any  discount  should  be  canceled  or  amortized  during  the  life 
of  the  bonds  by  the  appropriation  each  year  out  of  annual  income  or  surplus 
accumulated  after  the  issue  of  the  bonds  of  not  less  than  the  proportionate 
amount  of  the  discount."  The  Securities  Commission  also  said,  regarding 
the  issue  of  stock  below  par,  that  the  difference  between  par  value  and  cash 
received  should  be  amortized  within  a  short  term  of  years,  thus: 

If  a  document  says  one  hundred  dollars  has  been  paid,  one  hundred 
dollars  ought  to  be  paid.  The  most  that  can  properly  be  done  is  to  allow 
companies  which  cannot  sell  such  stock  at  par  to  arrange  for  the  "amor- 
tization," or  gradual  cancellation,  of  any  necessary  discount  by  appro- 
priating, out  of  future  income  or  surplus  which  may  accrue  subsequent 
to  the  issue  of  such  stock  an  annual  sum  having  precedence  over  dividend- 
payment,  to  be  so  applied  on  capital  account  as  to  make  the  deficiency  good 
in  a  period  of  no  very  great  length. 

In  order  that  this  difference,  which  is  in  the  nature  of  a  discount  upon 
securities,  may  be  eliminated  during  the  life  of  the  bonds,  it  is  necessary 
that  an  amount  should  be  set  aside  annually  out  of  income  before  dividends 
and  interest  on  the  income  bonds  may  properly  be  paid.  It  is  evident  that 
the  annual  amount  is  determined  by  the  rate  at  which  the  fund  will  accum- 
ulate. It  is  certainly  not  less  than  4  per  cent,  and  upon  this  basis  the 
annual  payment  would  be  $180,000,  plus  4  per  cent  upon  previous  pay- 
ments and  accumulations.    If  this  course  is  followed,  the  company  in  i960 


630  AUDITING— GENERAL  PRINCIPLES 

will  have  a  fund  which,  together  with  its  other  property,  assuming  it  to  be 
maintained  as  above  stated,  will  be  equivalent  to  the  par  value  of  the 
securities  then  outstanding. 

It  is  apparent  that  if  the  company  is  able  to  earn  only  4  per  cent  upon 
this  fund,  either  through  investments  in  securities  or  in  its  own  property, 
the  net  deduction  will  be  $180,000  per  annum.  If,  however,  the  company 
is  able  to  earn  even  more  than  4  per  cent  per  annum,  the  income  above  4 
per  cent  will  work  to  reduce  the  net  annual  charge  against  income  by  the 
precise  amount  which  the  actual  earnings  exceed  4  per  cent.  If,  for  ex- 
ample, the  company  should  be  able  to  earn  6  per  cent  per  annum,  the  net 
amount  would  be  less  than  $100,000. 

Unless  some  such  plan  is  followed,  the  company  will  not  be  able  in 
i960,  in  refunding  the  bonds  then  due,  to  present  as  the  basis  for  such  re- 
funding property  which  is  equal  to  the  par  value  of  the  securities.  They 
will  be  represented  in  part  by  discounts  upon  issues  of  191 2,  fifty  years 
before. 

Depreciation.  The  foregoing  requirement  has  reference  only  to  the 
present  impairment  of  capital.  This  impairment  of  capital  has  resulted 
to  a  considerable  extent  from  the  neglect  of  the  old  company  to  make 
proper  provision  for  depreciation.  If  the  company  does  not  reserve  a 
sufficient  portion  of  its  revenue  to  replace  capital  consumed  during  the 
year  but  not  requiring  replacement  within  the  year,  and  then  proceeds  to 
treat  the  entire  surplus  as  divisible  profits,  it  is  actually  violating  the 
corporation  law  against  the  declaration  of  dividends  out  of  capital  just  as 
effectually  as  though  it  sold  stock  and  distributed  the  proceeds  immed- 
iately in  the  form  of  dividends.  Unless,  therefore,  careful  provision  is 
made  for  the  creation  of  a  depreciation  reserve,  there  may  be  another 
repetition  of  the  financial  collapses  that  have  been  so  conspicuous  in  the 
history  of  the  street  railways  in  Manhattan. 

Under  the  Third  Article  of  the  first  refunding  mortgage  and  the  Fifth 
Article  of  the  income  mortgage,  the  company  agrees  and  covenants  to 
maintain  property  by  making  needful  repairs,  renewals,  and  replacements, 
and  under  the  Second  Article  of  the  refunding  mortgage  it  further  agrees 
that  no  bonds  shall  be  issued  for  replacements  or  operating  expenses.  To 
provide  for  such  replacements,  however,  there  ought  to  be  some  definite 
provision  for  a  depreciation  reserve.  The  matter  assumes  a  special  im- 
portance in  view  of  the  fact  that  the  declaration  of  interest  upon  the  in- 
come bonds  will  depend  upon  a  precise  definition  of  expenses  and  other 
deductions  that  may  be  made  from  revenue.  Without  clear  definitions 
there  is  an  almost  certain  likelihood  of  disputes  between  the  income  bond- 
holders and  the  stockholders  as  to  the  true  amount  of  the  profits.    The 


DEPRECIATION  63 1 

Second  Article,  Sub.  a,  of  the  income  mortgage  enumerates  the  various 
items  of  expense  to  be  deducted  from  revenue  and  specifies  depreciation  or 
obsolescence,  but  leaves  the  amount  of  such  charge  to  be  determined  en- 
tirely by  the  discretion  of  the  Board  of  Directors.  When  it  is  recalled  that 
in  one  case  where  it  was  the  object  of  the  company  to  show  small  earnings 
Receiver  Whitridge  testified  before  the  Commission  that  the  total  annual 
depreciation  amounted  to  $600,000,  and  that  in  a  second  case,  where  it  was 
the  object  of  the  company  to  show  large  earnings,  the  same  Receiver 
testified  that  depreciation  amounted  only  to  $300,000,  one  will  realize  the 
necessity  of  a  more  specific  definition  of  depreciation. 

In  the  opinion  of  the  Commission,  there  should  be  reserved  out  of 
revenue  for  the  upkeep  of  the  property,  including  both  current  main- 
tenance and  future  replacements,  in  accordance  with  the  accounting  rules 
of  the  Commission,  at  least  20  per  cent  of  the  operating  revenue  of  the 
Third  Avenue  Railway.  This  minimum  rate  has  been  used  in  other 
mortgages  and  contracts,  is  practically  the  standard  percentage  used  by 
engineers  in  appraising  street  railways,  and  more  especially  is  the  rate 
estimated  by  the  Chairman  of  the  Reorganization  Committee  of  the 
Metropolitan  Street  Railway  Company. 

The  Commission  does  not  fix  20  per  cent  as  the  maximum  rate  or  as  the 
rate  applicable  to  all  cases.  Further,  if  this  rate  should  prove  to  be  too 
high  after  a  number  of  years,  the  facts  may  be  presented  upon  application 
to  the  Commission  for  a  modification  of  this  order. 


Production  Method. — ^A  method  of  making  depreciation 
allowances  which  has  its  advantages  under  certain  conditions  is 
that  of  charging  an  established  rate  per  unit  of  output.  This  is 
especially  applicable  in  the  case  of,  say,  a  blast  furnace  where 
the  frequency  with  which  the  linings  will  need  to  be  renewed 
depends  on  the  extent  to  which  the  furnace  is  being  used.  If  it  is 
being  run  at  full  capacity  night  and  day,  the  wear  on  the  linings  is 
obviously  much  greater  than  if  the  furnace  had  not  been  in  con- 
tinual use  during  the  entire  fiscal  period. 

Another  species  of  depreciation  which  may  be  said  to  come 
under  the  above  caption  is  that  caused  in  a  plant  by  the  depletion 
of  the  mines  or  timber  lands  in  connection  with  which  the  plant 
was  constructed.  Most  of  the  value  of  coke  ovens,  for  instance,  is 
gone  when  the  mines  for  which  they  were  constructed  are  worked 


632  AUDITING— GENERAL  PRINCIPLES 

out.  Consequently,  in  determining  the  amount  to  be  written  off 
for  depreciation  of  mining  and  lumbering  plants,  the  factor  of  the 
probable  future  output  of  the  mines  or  lands  is  an  important  one 
and  it  is  frequently  found  advisable  to  base  the  plant  depreciation 
charge  on  the  output.  Certainly  this  should  be  done  where  it  is 
evident  that  the  plant  will  outlive  the  exhaustion  of  the  mines  or 
lands.  In  such  cases  the  depreciation  charges  should  be  sufficient 
to  absorb  the  entire  cost  of  the  plant,  less  residual  value,  by  the 
time  the  mines  or  lands  are  exhausted,  even  though  at  that  time 
the  plant  may  still  be  in  good  operating  condition. 

The  auditor  should  note  that  the  depreciation  charge  has  been 
brought  into  the  books  of  account  properly.  This  is  important 
because,  to  constitute  an  allowable  deduction  for  income  tax 
purposes,  the  depreciation  allowance  must  be  charged  off  on  the 
books.  ^ 

Sinking  Fund  Requirements  to  Retire  Bonds,  etc.,  Must  Not  Be 
Confused  with  Depreciation  Allowances 

The  trained  accountant  or  engineer  recognizes  the  distinction 
between  provision  for  depreciation  and  appropriations  for  sinking 
funds,  and  so  never  confuses  the  two  terms.  Not  so,  however, 
with  lawyers  and  business  men. 

The  modern  industrial  bond  is  not  popular  imless  a  provision 
is  inserted  in  the  trust  deed  requiring  that  a  sufficient  sum  be  set 
aside  annually,  or  otherwise,  to  retire  the  bonds  before  or  at 
maturity.  It  is  usual  to  stipulate  that  the  instalments  must  be 
provided  out  of  earnings,  and  this  is  a  wise  course  to  follow, 
because  it  serves  to  keep  down  dividend  declarations  during  the 
life  of  the  bonds.  Nevertheless,  the  sinking  fund  instalments 
are  capital  expenditure  and  do  not  properly  appear  among  operat- 
ing expenses,  but  should  be  stated  as  deductions  from  the  net 
income  when  ascertained.  This  course  fulffis  the  obligation 
imposed  in  the  trust  deed  and  yet  does  not  permit  the  surplus  to 
be  overstated. 


^  See  Income  Tax  Procedure,  1921,  pages  847-848. 


DEPRECIATION  633 

The  sinking  fund  provision  may  be  greater  or  less  than  the 
amount  required  for  depreciation,  aside  from  the  fact  that  one  is 
an  operating  expense  and  the  other  is  a  discharge  of  a  capital 
obligation.  Therefore,  depreciation  should  be  calculated  and 
charged  against  earnings  before  the  net  income  is  determined, 
irrespective  of  the  existence  or  non-existence  of  sinking  fund 
requirements. 

The  common  misconception  of  the  proper  treatment  of  com- 
pulsory sinking  funds  can  be  explained  by  an  illustration  taken 
from  actual  practice.  A  manufacturing  corporation  handling 
a  patented  device  issued  bonds  aggregating  $375,000,  payable  in 
instalments  of  $25,000  annually  for  fifteen  years.  Having  in  mind 
possible  competition  and  obsolescence  of  its  property,  it  was  pro- 
vided that  the  sinking  fund  instalments  be  charged  against  income. 
The  president  of  the  company  had  a  contract  under  which  he  was 
to  receive  a  bonus  of  5  per  cent  of  the  net  income  in  addition  to  his 
salary,  but  it  was  specifically  provided  that  as  to  him  the  charges 
against  income  should  not  include  the  sinking  fund  instalments. 
In  making  up  the  first  year's  accounts  the  auditors  decided  that 
the  depreciation  reserve,  as  nearly  as  could  be  determined,  should 
be  stated  as  $25,000,  and  this  amount  was  included  among  the 
operating  expenses. 

When  their  report  was  submitted  to  the  directors,  the  presi- 
dent referred  to  his  contract  and  stated  that  the  sinking  fund 
provision  and  depreciation  were  synonymous  and  that  he  was 
entitled  to  5  per  cent  of  the  net  income  before  any  deduction  was 
made  for  depreciation.  The  majority  of  the  directors  agreed 
with  him,  with  the  result  that  the  company  has  overpaid  the 
president  $1,250  per  annum  for  several  years. 

Perhaps  the  time  will  arrive  when  depreciation  will  be  gener- 
ally considered  as  a  prime  operating  cost.  If  it  is  so  treated 
throughout  the  accounts,  no  such  misunderstanding  as  that 
above  cited  could  occur. 

The  United  States  Steel  Corporation  transfers  a  large  part  of 
the  amounts  credited  to  its  depreciation  funds  to  the  trustees  of 


634  AUDITING— GENERAL  PRINCIPLES 

the  bond  sinking  funds.  The  corporation's  and  its  subsidiaries' 
bonds  are  then  redeemed  from  this  fund  and  the  amount  of  the 
bonds  so  redeemed  do  not  appear  as  a  sinking  fund  asset  or  a 
bond  HabiHty.  This  amount,  however,  appears  as  a  part  of  the 
depletion  and  depreciation  fund  balance  deducted  from  the 
property  account  with  the  following  caption,  "invested  in  re- 
deemed bonds  held  by  trustees  of  sinking  funds,  but  not  treated 
as  assets." 

Cost  the  Proper  Basis 

The  question  of  depreciation  should  be  considered  only  in 
connection  with  the  cost  of  the  item  to  be  depreciated.  ^  The 
fact  that  the  value  of  the  property  has  increased  or  decreased  and 
that  the  cost  of  the  replacement  may  be  greater  or  less,  should 
have  no  bearing  on  the  amount  to  be  set  aside.  However,  if,  for 
instance,  it  is  the  intention  of  the  management  to  purchase 
replacements  costing,  say,  double  the  price  of  the  original  prop- 
erty without  new  financing,  then  amounts  should  be  reserved  for 
this  purpose  from  surplus. 

Depreciation  Is  an  Operating  Expense 
1^  We  often  see  a  statement  in  published  reports  that  a  corpo- 
ration has  realized  net  income  amounting  to  a  certain  sum,  and 
that  out  of  this  net  income  an  allowance  for  depreciation  has  been 
made.  It  is  just  as  logical  to  state  that  a  candy  manufacturer 
had  earned  net  income  of  $100,000  and  that  out  of  said  $100,000 
there  has  been  set  aside  $20,000  to  pay  for  the  sugar  consumed 
in  the  manufacture  of  the  product. 

The  use  of  that  which  is  consumed  is  a  loss  or  expense. 
Machinery  is  consumed;  sugar  is  consumed.  You  cannot  say 
that  one  is  an  operating  expense  and  the  other  is  an  item  which 
need  not  be  ascertained  or  taken  into  account  until  the  net  income 


7  This  proper  accounting  principle  is  modified  when  tax  laws  or  similar 
causes  call  for  special  treatment.  For  federal  tax  purposes  depreciation 
should  be  calculated  on  fair  values  as  of  March  i,  19 13.  for  property  acquired 
prior  to  that  date. 


DEPRECIATION  635 

is  shown.  Net  income  means  only  one  thing  in  the  vocabulary  of 
the  professional  auditor,  that  is,  the  excess  of  income  over  operat- 
ing costs,  expenses,  and  losses.  It  cannot  be  determined  by 
taking  into  account  all  of  the  income  and  a  part  only  of  the 
charges  against  it.  If  the  provision  for  depreciation  is  not  such 
an  item  as  can  he  included  among  the  costs  of  operation,  then 
it  is  a  misnomer. 

This  view  of  depreciation  is  well  expressed  by  the  late  Professor 
Henry  C.  Adams,  writing  on  railroad  accounts,  but  the  principle 
enunciated  applies  with  equal  force  to  industrial  accounts. 

When  carried  to  its  final  analysis  the  question  of  formal  depreciation 
charges  to  operating  expenses  is  simply  a  question  of  what  constitutes  cost 
of  operation,  and  the  time  when  such  cost  shall  be  acknowledged  in  the 
accounts.  The  position  which  the  Interstate  Commerce  Commission's 
system  of  accounts  assumes  on  this  point  is,  that  the  depletion  of  an  asset 
which  represents  an  investment  through  the  use  of  that  asset  in  operation 
creates  an  item  of  cost  of  operation  which  should  be  reflected  in  the  ac- 
counts when  the  fact  of  such  depletion  takes  place,  and  that  a  statement  of 
net  revenue  made  without  including  this  element  of  cost  in  operation  ex- 
penses is  an  erroneous  statement. 

After  all,  the  problem  is  not  so  very  difficult.  It  requires 
comparatively  little  additional  work  to  determine  the  depreci- 
ation for  each  shop  or  department,  and  to  apportion  this  each 
month  to  the  department  or  shop  to  which  it  belongs.  If  it  is 
thus  handled  in  detail  from  month  to  month,  we  are  relieved  of 
the  complicated  task  of  attempting  to  calculate  it  at  the  end  of  a 
fiscal  year  on  the  plant  and  equipment  as  a  whole. 

Depreciation  a  Local  Issue 

The  auditor  must  use  his  own  judgment  in  passing  on  rates  of 
depreciation,  just  as  much  as  he  does  when  he  inspects  purchase 
vouchers.  In  one  locality  steam  coal  may  be  $3  a  ton;  in  an- 
other, $6.  The  variation  may  be  entirely  legitimate.  In  one 
locality  boilers  may  depreciate  73^  per  cent  annually,  in  another 
the  rate  may  be  15  per  cent. 

It  is  not  merely  a  question  of  the  life  of  the  boilers,  because  no 


636  AUDITING— GENERAL  PRINCIPLES 

experienced  engineer  or  boiler  manufacturer  can  answer  the 
question  unless  he  knows  the  use  to  which  the  boiler  is  subjected, 
the  climate,  the  water,  the  class  of  labor,  the  probabiHties  of 
shut-downs,  etc.  And  similarly  with  almost  all  other  classes  of 
property  which  depreciate  by  wear  and  tear.  Therefore,  wher- 
ever rates  of  depreciation  are  mentioned  in  this  chapter,  they 
must  be  taken  as  suggestive  only  and  in  a  relative  sense.  The 
student  without  other  experience  can  thus  broadly  acquaint 
himself  with  general  observations  and  modify  his  views  later  on 
as  he  gains  experience.  ^ 

Investment  of  Depreciation  Reserves 

It  has  been  urged  that  unless  an  amount  corresponding  to  the 
reserve  for  depreciation  is  invested  in  marketable  securities,  it  is 
not  a  de  facto  reserve,  but  merely  a  book  account;  but  this  is 
really  a  matter  of  secondary  importance.  The  principal  point  to 
consider  is  whether  or  not  there  has  been  charged  to  income  a 
sufficient  sum  to  cover  the  loss  caused  by  wear  and  tear  and 
obsolescence.  So  long  as  this  is  done  there  is  no  possibihty  of 
the  amount  thereof  being  paid  out  in  dividends.  It  is  left  in  the 
business  in  the  form  of  cash  or  any  other  undivided  asset.  The 
question  of  its  investment  is  immaterial. 

The  concern  that  can  and  does  purchase  securities  equal  to  its 


*"The  rate  of  depreciation  depends  upon  many  different  and  variable 
factors,  some  of  the  most  important  of  which  are  as  follows: 

(a)  Nature  and  construction  of  buildings  and  equipment,  together  with 
their  condition. 

(b)  Deterioration  of  plant  in  general  and  of  machinery  in  particular,  due 
to  wear  and  tear. 

(c)  Amount  spent  for  maintenance  in  the  way  of  repairs  and  renewals. 

(d)  The  invention  of  new  methods  or  new  machines  which  may  or  may 
not  entirely  replace  the  old  ones. 

(e)  Permanency  of  business,  and  likelihood  of  increase  or  decrease  in  the 
same. 

(f)  Amounts  previously  written  off  for  depreciation. 

(g)  There  are  many  additional  factors,  such  as  amortization,  peculiar  and 
excessive  uses  of  machines,  rate  of  production,  idleness  of  plant,  etc.,  all  of 
which  enter  into  the  problem."  (Uniform  Contracts  and  Cost  Accounting 
Definitions  and  Methods,  U.  S.  Government  Interdepartmental  Conference. 
1917,  page  7-) 


DEPRECIATION  637 

depreciation  reserve  and  retains  such  securities  until  the  proceeds 
are  needed  for  the  purchase  of  machinery,  etc.,  can  certainly  be 
depended  upon  to  renew  its  machinery  when  necessary,  even 
though  its  depreciation  reserve  is  represented  among  its  current 
or  fixed  assets. 

The  life  of  plant  and  equipment  is  too  uncertain  to  warrant 
the  purchase  for  purposes  of  the  depreciation  reserve,  of  bonds 
which  are  to  be  sold  to  finance  renewals.  A  well-managed  plant 
is  attended  to  daily  as  to  its  up-keep,  and  renewals  and  changes 
are  made  as  needed. 

Importance  of  Provision  for  Obsolescence 

It  has  been  pointed  out  that  actual  depreciation  is  ascertain- 
able. That  is  to  say,  machinery,  for  instance,  cannot  be  operated 
efficiently  if  it  falls  below,  say,  70  per  cent  of  its  condition  when 
new.  If  its  theoretical  life  is  ten  years  and  30  per  cent  has  been 
set  aside  during  the  first  three  years,  the  question  then  arises, 
what  to  do  at  the  end  of  the  fourth  year.  If  the  shop  is  properly 
managed,  it  is  probable  that  the  machine  is  worth  to  a  going 
business  70  per  cent  of  its  cost  and  will  remain  so  until  superseded. 
But  no  manufacturer  can  depend  on  keeping  up  his  equipment  by 
renewing  old  machines  in  whole  or  in  part.  It  is  inevitable  that 
improvements  will  come  so  long  as  the  times  produce  inventors 
and  men  of  initiative.  Therefore  the  manufacturer  who  is  willing 
that  the  product  of  a  machine  shall  bear  the  cost  of  the  machine 
continues  to  charge  operating  and  to  credit  reserve  for  depreci- 
ation with  such  an  amount  as  enables  him  to  discard  his  old  ma- 
chine as  soon  as  a  better  one  appears. 

One  of  the  foremost  efficiency  engineers  in  this  country  told 
the  author  that  the  tendency  to  scrap  old  machines  and  buy 
new  ones  has  often  been  carried  to  an  extreme;  that  in  some 
cases  a  new  machine  of  twice  the  capacity  of  an  old  one  costs 
much  more  than  twice  as  much,  and  that  the  interest, 
depreciation,  and  other  charges  against  the  new  machine  more 
than  offset  the  saving  in  time  or  increase  in  production. 


638  AUDITING— GENERAL  PRINCIPLES 

Nevertheless,  the  tendency  to  discard  machinery  is  strong, 
and  the  auditor  who  endeavors  to  charge  out  the  cost  of  a  machine 
against  its  product  must  set  up  a  reserve  for  depreciation 
sufficient  to  include  ordinary  obsolescence,  or  he  will  find  the 
reserve  insufficient.  ^ 

It  is  not  advisable  to  set  up  a  reserve  for  ordinary  obso- 
lescence separately  either  in  the  books  or  in  financial  statements. 
No  manufacturer  cares  to  publish  his  estimate  of  that  part  of  his 
equipment  which  is  getting  out  of  date. 

Depreciation  of  Different  Classes  of  Property 

Passing  from  a  general  discussion  of  the  rules  which  have  the 
approval  of  competent  authorities,  it  is  desirable  to  study  their 
application  to  various  classes  of  assets.  For  the  sake  of  con- 
venience we  will  take  up  the  depreciation  of  fixed  assets  as  they 
appear  elsewhere  in  this  book. 

Before  doing  so  it  will  be  of  interest  to  note  the  variation  in 
rates  which  apply  to  different  classes  of  property,  as  given  on 
pages  639-643.  These  tables  are  prepared  from  the  exhaustive 
compilation  of  depreciation  rates  which  appears  in  the  Account- 
ants' Index,  published  by  the  American  Institute  of  Accountants. 
The  table  should  be  of  assistance  to  the  auditor  in  making  deci- 
sions on  this  subject. 

Land 

It  is  usual  to  dismiss  this  item  with  the  statement  that  land  does 
not  depreciate.  Nothing  could  be  further  from  the  facts.  The  great 
bulk  of  arable  land  in  the  United  States  is  depreciating  through  use 
just  as  much  as  depreciation  occurs  in  machinery  through  use. 

The  land  on  which  buildings  are  erected  or  which  is  used  for 
storage  purposes,  etc.,  may  not  depreciate,  and  the  aggregate  of 


9  See  Saliers,  Principles  of  Depreciation,  pages  29-30,  for  a  discussion  of  the 
methods  of  figuring  obsolescence. 

For  a  full  discussion  of  special  problems  relating  to  obsolescence  which  have 
resulted  from  the  war,  see  Montgomery,  Income  Tax  Procedure,  1921,  pages 
902-920. 


DEPRECIATION 
Depreciation  Rates 


639 


1 

ii 

.S-a 

is 

I.I 

.CO 

Iff 

sh'-' 

1 

(1) 

(2) 

(3) 
20 

Agricultural  machinery. .  .  . 

10 

6     -12 

3 
20 

3 

Motor  trucks 

10 
10 

20 
20 

25 
25 

20 

Pleasure  cars 

Barns: 
Brick 

3 

Frame            

4 

Frame    (without    good 

4H 

6.6 

6 

7 

5 

10 

714 

5 

Belting 

5 
6.6-8.5 

10    -  331^ 

Boilers. . . 

5 

5 

6.6 

5     -20 

Bridges: 

Masonry 

1 

Steel 

3 

Wood 

10 

Trestles  (not  including 
rails  or  ties): 
Steel 

3H 

QH 
2H 
2 
5 

Wood 

Buildings: 

Brick 

4 

21^-3 

Concrete 

IM 

2 

4-   5 
8H 

2 

Wood 

iy2'  5 

2>^-  5 
4-6 

Cables: 

Underground 

2H 

Aerial  lines 

5 

Tramway  cables 

3 

2H-   5 
10 

Carpets  and  rugs 

Cash  registers 

5 

15 
15 

Chemical    manufacturers' 
apparatus 

Coal  and  ash  handling  ma- 
chinery   

10 
2 

6.6 

8 
2 

5 

5     - 10 

Conduits 

2 

(1)  Written  down  value,  repairs  allowed  in  addition. 

(2)  Written  down  value, 

(3)  Based  on: 

(a)  The  cost  of  equipment. 

(b)  The  life  of  the  equipment. 

(c)  On  a  ten-hour  day. 


640 


AUDITING— GENERAL  PRINCIPLES 
Depreciation  Rates 


1 

'Ms 

CO  ^ 
C  00 

1^ 

»l 

.CO 

>> 

1 

111 

ji 

Containers: 

Casks 

(1) 
25 

(2) 

(3) 

7j4  -20 

Crates 

Conveying  and  hoisting  ma- 

6M-10 

Cotton  mills: 

5 

7H 

Dwellings: 
Frame 

3 

2^  -   4J^ 

IH  -   2H 

5 

7M-10H 

5 

5    -   7M 

7H 

5 

5 
10 
5 

7H 

Elevators 

Engines: 
Gas 

5 

10 

Steam.             

5 

5-6.6 

6.6 

3     -121^ 

Fences: 
Wire 

Wooden 

7}4 

Flour  mills: 

Machinery  (other  than 
power) 

7M 

7M 
5 

Engines,  boilers,  and 

5 

Brick  or  stone  buildings 

2      -    2M 

3     -    3H 

Foundries: 
Buildings: 
Concrete 

2^ 

Brick 

3     -   S^ 

5     -10 

Wood 

7H 

Furnaces 

15 

7H-10 

3 

10-20 
15 
15 

Flasks,  patterns,  and 

2 

IS 

6 
10 

5 

Furniture  and  fixtures 5 

5     -25 

(1)  Written  down  value,  repairs  allowed  in  addition. 

(2)  Written  down  value. 

(3)  Based  on: 

(a)  The  cost  of  equipment. 

(b)  The  life  of  the  equipment. 

(c)  On  a  ten-hour  day. 


DEPRECIATION 


641 


Depreciation  Rates 


Australia 

Federal  Income 

Tax  Dept. 

IF 

2.1 

11 

1% 
•^0 

Chicago 

Union 

Traction  Co. 

Montgomery's 

Income 

Tax 

Nicholson  and 

Rohrbach's 
Cost  Accounting 

Milwaukee 
Elec.  Ry.  & 
Light  Co. 

1 

Generators— electric 

Harness 

(1) 
5 
10 

(2) 

5 

6.6 

(3) 
5 

7M 

5 

10    -  123^ 

Heating  and  ventilating 

10 
15-25 

5 

10 

Horses: 

Horses                    

10     -25 

10 

12 
10 

6K 

10     -  12 

Laboratory  eauipment 

10 

Lathes 

10 

Laundries: 

8 

8H 

Laundry  plant 

5 

Locomotives  for  local  trans- 
portation: 
Steam             

m 
&% 

3     -  10 

Electric 

2     -  10 

Lumber  mills: 

Engines,    boilers,    and 
main  shafting 

5 
20 

General  saw  milling 
plant  and  machinery 

Traction  engines,  trac- 
tors, motor  cars  and 
haulage  plant  .    . . 

Machinery: 

Machinery  and  equip- 

6-10 

5     -  15 

Ordinary  manufactur- 

5 

10     - 15 

Meters: 

Electric 

4     -    714 

Gas 

5     -  10 

Oil 

10 

Water 

2  1-3 

7H 

5 

5 

6.6 

5 



534 

5     -    7H 

Paper  mills: 
Machinery: 

Working  day  only 

Working  day  and 

2y2-  SH 

(1)  Written  down  value,  repairs  allowed  in  addition. 

(2)  Written  down  value. 

(3)  Based  on: 

(a)  The  cost  of  equipment. 

(b)  The  life  of  the  equipment. 

(c)  On  a  ten-hour  day. 

VOL.  I — 41 


642 


AUDITING— GENERAL  PRINCIPLES 


Depreciation  Rates 


Hi 

■s  a 

1" 

lei 

J" 

III 

Iff 
ft 

Milwaukee 

Elec.  Ry.  & 

Light  Co. 

s 

Patterns— Standard: 

(1) 

(2) 

(3) 

75 
100 

Wood,  net  additions. . . 

Paving: 

Asphalt 

7 

Block 

2M 

Brick 

4M  -    7 

Granite 

5 

Macadam 

6 

Piping 

5 

6.6 

7M 
6 

7K 

6 

m  -    5 

Printing: 

Printing    and    binding 
machines 

7K2 
7M 
7K2 

7K2 
10 

73^  -  10 

Type 

10      -25 

Pumps 

6?^ 

5 
4 

4      -    6K 

Roadways  and  sidewalks 

Rolling  stock: 

Industrial 

5-7 

5-7M 
5 

IH  -15 

Owned  by  railways .... 

2K2 

7K2 

5-6% 

5-8y2 

6-7M 

4     -10 

Sawmills 

6^ 

6^-10 

Shafting,  pulleys,  etc 

5 
5 

3 
8 
4 
6 
5 
5 

4H 
8 

7H 

5 

3      -  15 

Sprinkler  systems. 

5 

5 

Stacks: 

Brick 

3     -   5 

Steel 

6     -10 

4 

Steam  power  plants 

5 

Sub-station  equipment. . . . 

3      -    5 

Switchboards  and  wiring . . . 

2-5 

6.6 

3      -    8 

^  Tanks: 

Steel 

4>^ 

Wood 

9 

Telephone  equipment. .    . 

5 
20 

7H 
5 

5 

Tools: 

10     -  33H 

5 
20 

5 

5     -12"^ 

Turbines — steam. . 

5 

6^ 

10 

7H 

20 

Vehicles,  carts,  wagons,  etc. 

7K-20 

(1)  Written  down  value,  repairs  allowed  in  addition. 

(2)  Written  down  value. 

(3)  Based  on: 

(a)  The  cost  of  equipment. 

(b)  The  hfe  of  the  equipment. 

(c)  On  a  ten-hour  day. 


DEPRECIATION 
Depreciation  Rates 


643 


111 

IF 

0  S 

|6 

III 
6^1 

>> 

m 

Pi 

ft 

J 

i 

Warehouses: 

Modern  fireproof  steel 
and  tile 

(1) 

(2) 

(3) 

3 

4 

Steel  construction 

..   .. 

3 

Wooden,  of  poor  con- 

8 

Fixtures 

8 

Wharves: 

Docks,  pieis  and 

3M 
5 

5 

3 

Wiring  (inside) 

5 

7H 

6 

Wires  and  cables 

6.6 

(1)  Written  down  value,  repairs  allowed  in  addition. 

(2)  Written  down  value. 

(3)  Based  on: 

(a)  The  cost  of  equipment. 

(b)  The  life  of  the  equipment. 

(c)  On  a  ten-hour  day. 

such  holdings  is  very  large,  but  the  auditor  must  inquire  into  the 
purpose  for  which  land  is  used,  its  location,  etc.,  before  he  can 
decide  offhand  that  the  land  has  not  depreciated. 

Land  used  for  agricultural  purposes  may  depreciate  through 
use,  and  does  unless  a  certain  rotation  of  crops  is  followed  or 
unless  fertilizers  are  used.  The  cost  of  the  latter  is  equivalent  to 
the  cost  of  maintenance  and  repairs  in  a  factory. 

The  price  of  flaxseed  has  increased  enormously  because  during 
the  early  years  of  farming  in  the  West  the  vitality  of  the  land  was 
exhausted  by  that  crop  to  such  an  extent  that  the  farmers  were 
obliged  to  discontinue  raising  it.  While  this  crop  was  exhausting 
the  land,  the  farmers  should  have  set  up  a  reserve  for  depreci- 
ation. It  would  then  have  been  apparent  that  the  net  income 
realized  from  the  flax  crop  was  not  nearly  so  high  as  it  seemed, 
and  that  wheat,  while  bringing  in  less  cash  per  acre,  would  have 
been  more  profitable. 


644  AUDITING— GENERAL  PRINCIPLES 

This  illustration  may  not  seem  pertinent  enough  to  warrant  its 
inclusion  in  a  book  which  is  intended  to  be  practical  but  the  author 
wishes  students  in  particular  to  use  their  imagination  on  every 
possible  occasion.  This  is  a  convenient  place  to  reiterate  the 
advice.  Heretofore  textbooks  on  auditing  have  stated  without 
qualification  that  land  does  not  depreciate.  If  three-fourths  of 
the  land  in  the  United  States  is  depreciating  through  use,  such 
statements  should  not  go  unchallenged. 

Land  fluctuates  in  value,  sometimes  violently,  but  such 
fluctuations  are  not  to  be  confused  with  depreciation. 

Buildings 

It  is  difficult  to  foretell  at  what  rate  buildings  will  depreciate, 
and  it  is  practically  impossible  to  set  a  standard  common  to  all 
the  different  classes  of  buildings  which  are  found  among  the  assets 
of  various  enterprises.  When  one  ledger  account  includes  both 
land  and  buildings,  the  depreciation  usually  must  be  confined  to 
the  buildings.  As  a  general  rule,  if  the  allowances  for  deprecia- 
tion take  the  form  of  the  instalment  plan,  the  annual  rate  of 
deduction  ranges  from  i  to  5  per  cent  of  the  original  amount,  the 
rate  varying  according  to  the  workmanship,  material,  service  to 
which  the  building  is  put,  climate,  and  any  other  factor  which 
may  influence  the  life  of  the  building.  By  the  sinking  fund 
system  the  sum  to  be  set  aside  must  be  such  as  will  accumulate 
to  the  cost  of  the  building  during  the  probable  Hf  e  of  the  building. 
Repairs  must  be  charged  to  income,  in  addition  to  the  charge  for 
depreciation. 

It  must  be  remembered  that  no  building  will  last  forever. 
This  statement  is  made  in  the  face  of  the  contrary  claims  of  the 
advocates  of  concrete  construction.  Possible  appreciation  in 
land  should  not  be  used  as  an  offset  against  the  depreciation  of 
buildings,  unless  the  former  is  included  in  income  and  the  charge 
for  depreciation  is  included  among  the  expenses.  It  is  then 
apparent  that  an  anticipated  profit  is  being  used  to  offset  an 
actual  expense. 


DEPRECIATION  645 

A  prominent  engineer  says  that  a  building  in  which  rapidly 
revolving  shafting  is  employed,  or  in  which  machines  operate 
with  considerable  shock,  such  as  a  number  of  drop  forge  hammers, 
depreciates  rapidly;  and  that  for  such  buildings  a  yearly  depreci- 
ation of  from  4  to  8  per  cent  should  be  allowed. 

A  leading  appraisal  company  states  that  for  some  concrete 
buildings  only  two  or  three  years  old,  it  is  necessary  to  apply  a 
high  rate  of  depreciation  because  the  cement  mixtures  used  do 
not  accord  with  first-class  practice. 

New  York  Ruling.— The  New  York  State  Income  Tax 
Bureau,  in  replying  to  questions  on  this  subject,  stated:  "Gen- 
erally, depreciation  may  be  taken  at  the  rate  of  4  per  cent 
yearly  on  a  frame  building  and  3  per  cent  yearly  on  a  brick 
building.  These  amounts  should  cover  both  repairs  and  de- 
preciation." 

Demolition  of  Buildings.— It  should  be  noted  that  for 
income  tax  purposes  the  Treasury  does  not  allow  as  a  deductible 
loss  the  cost  of  demolition  of  buildings  for  purposes  of  recon- 
struction. It  regards  the  amount  expended  as  an  investment 
of  capital  to  be  considered  as  a  part  of  the  cost  of  reconstruction. 
This  permits  corporations  to  carry  on  their  books  the  depreciated 
cost  of  an  original  investment,  or  part  of  it,  after  the  asset  repre- 
senting that  investment  has  been  destroyed;  and  in  addition 
permits  the  book  value  of  the  destroyed  asset  to  be  increased  by 
the  cost  of  destroying  it.  ^** 

Also  it  should  be  noted  th^t  buildings  under  construction  are 
not  subject  to  depreciation  allowances  for  income  tax  purposes. 
The  allowance  begins  with  the  beginning  of  the  useful  life  of  the 
building.  The  term  ''useful  life "  has  been  interpreted  as  mean- 
ing the  period  during  which  an  asset  may  be  used  for  the  purpose 
for  which  it  was  acquired. " 

'"  Cumulative  Bulletin  Number  4,  page  178;  O.D.  845. 
'  ^  Ihid. 


646  AUDITING— GENERAL  PRINCIPLES 

Leaseholds 

Premiums  paid  for  leases  may  be  considered  as  the  price  of  a 
terminable  annuity  equal  in  amount  to  the  difference  between 
the  annual  value  and  the  annual  charges.  In  case  of  short-term 
leases  it  is  most  convenient  to  charge  a  proportionate  par.  against 
each  year's  revenue,  but  this  method  is  not  desirable  in  case  of 
longer  leases,  because  it  is  not  sufficiently  accurate.  The  an- 
nuity method  is  more  desirable  where  long  leases  are  concerned, 
because  the  early  years  should  not  bear  the  carrying  charges  on 
the  full  purchase  price  in  addition  to  a  prorated  instalment  of 
the  principal. 

Sometimes  at  the  expiration  of  a  lease  there  arises  a  ciaim 
for  damages  based  on  the  condition  of  the  premises.  It  is  not 
usually  possible  to  restrict  the  use,  under  along  lease,  to  ordinary 
wear  and  tear.  The  amount  thereof  varies  according  to  circum- 
stances, but  the  possibility  of  this  contingency  must  be  taken 
into  consideration  in  making  the  calculation.  When  a  lease 
requires  the  restoration  of  the  premises  at  the  termination 
of  the  lease,  to  their  original  condition,  the  estimated  ex- 
pense of  such  restoration  may  be  spread  over  the  term  of  the 
lease,  and  an  amount  thus  reserved  sufficient  to  make  the 
restoration. 

In  England,  where  leaseholds  are  far  more  common  than 
in  the  United  States,  the  annuity  system  is  usually  applied. 
Under  it  interest  on  the  investment  is  charged  each  year  on 
the  diminishing  value  of  the  lease.  The  amount  of  deprecia- 
tion is  fixed,  but  as  the  reserve  grows  larger  the  interest  charges 
decrease. 

When  new  buildings  are  erected  on  leased  land  the  full  cost 
thereof  must  be  charged  off  during  the  term  of  the  lease,  unless 
there  is  provision  for  revaluation  at  its  expiration.  In  any  event 
the  expired  value  of  the  assets,  as  shown  at  the  time  of  expiration 
of  the  lease,  must  be  absorbed  equitably  during  its  term.  The 
annuity  system  is  suggested  as  the  plan  most  suitable  for  this 
purpose. 


DEPRECIATION  647 

Machinery  and  Equipment 

The  proper  rate  of  depreciation  for  machinery  has  been  the 
subject  of  more  discussion  than  any  other  allowance  of  this  nature. 
So  many  factors  enter  into  the  life  of  machinery  that  it  is  abso- 
lutely necessary  for  each  machine  to  carry  its  own  individual  rate. 
This  can  be  determined  solely  by  experience.  In  case  of  two  like 
machines  used  in  different  factories,  there  may  be  a  considerable 
difference  in  length  of  life  and  service ;  consequently  no  hard-and- 
fast  rule  can  be  laid  down.  But  in  addition  to  charging  all 
repairs  and  part  renewals  to  operating,  from  5  to  121^  per  cent 
should  be  written  off  annually  from  the  original  cost  to  pro- 
vide for  normal  depreciation  from  wear  and  tear  and  ordinary 
obsolescence. 

Regardless  of  obsolescence,  the  life  of  a  heavy  machine  tool  is 
usually  considered  as  from  15  to  20  years.  The  rate  adopted  by 
the  National  Machine  Tool  Builders'  Association  for  machinery 
is  10  per  cent.  This  rate  implies  favorable  conditions  and  is  to 
be  figured  on  original  cost. 

A  subsidiary  ledger  should  invariably  be  kept  containing 
details  of  the  summary  machinery  accounts  which  appear  in  the 
general  ledger.  This  aids  in  determining  rates  of  depreciation 
and  is  of  great  value  in  case  of  fire  or  in  determining  the  amount 
to  be  written  off  in  case  of  sale.  When  the  items  are  of  sufficient 
importance,  a  separate  account  should  be  kept  for  each  item  with 
original  cost,  additions,  deductions,  and  a  memorandum  record 
of  the  amount  of  depreciation  charged  to  date. 

Repairs  versus  Depreciation. — A  part  of  cost  of  the  ordi- 
nary wear  and  tear  for  which  depreciation  reserves  are  created  is 
sometimes  charged  to  operating  expenses  as  repairs  and  mainte- 
nance. Small  parts  of  machines  are  constantly  wearing  out 
or  breaking  and  being  renewed.  In  some  cases  nearly  every 
part  of  a  machine  is  renewable,  and  it  is  quite  conceivable  that 
at  the  end  of  five  or  six  years  a  machine  may  be  largely  renewed 
and  be  about  as  good  as  new.     If,  under  these  conditions,  depreci- 


648 


AUDITING— GENERAL  PRINCIPLES 


ation  at  the  rate  of  10  per  cent  per  annum  is  reserved,  without 
any  adjustment  for  new  parts  supplied,  it  is  evident  that  the 
reserve  is  too  large. 

A  reduction  in  ordinary  depreciation  rates  is  not  advocated, 
but  the  careful  auditor  should  study  the  relation  existing  betw^een 
the  depreciation  reserve  and  the  physical  condition  of  the  ma- 
chine. Professor  Cooley's  description  on  page  624  reminds  us  that 
machinery,  to  serve  its  purpose  properly,  must  be  maintained  at 
from  75  to  85  per  cent  of  its  original  condition;'''  therefore  there 
is  no  necessity  for  providing  the  cost  of  maintenance  plus  the 
wear  and  tear  element  of  depreciation  if  the  latter  is  fully  covered 
by  the  former. 

Authoritative  Rates.— The  following  tables  compiled  by 
George  A.  Cravens  and  published  in  the  Electrical  Review,  April 
21,,  1 9 10,  are  of  interest.  Rates  of  depreciation  on  various  kinds 
of  equipment  as  estimated  in  connection  with  litigation  and  by 
recognized  authorities  are  shown. 

Table  II  indicates  the  variation  caused  by  light  or  heavy  use. 


Table  1 

c 

■Hd 

TJ 

Items 

0 
y  2 

u 

^5 
II 

^0£ 

C 
W 

2 

< 

0 

h 

bog 
S 

1 

C 

0 

c 

P4 
Of 

n 

Wi 

CO 

V  ^ 

c  3 

(4  u 

Boilers 

3.5-10 

f,f, 

7  >> 

6.6-8.5 

s 

8-10 

5 

2.5-3.3 

4-6.6 

7.5 

Steam    Piping 

3.5 

6.6 

7.5 

5 

5 

5 

8-10 

5 

2.5-3.3 

5-8 

5 

Auxiliaries 

5-10 

6.6 

5 

6.6-8.5 

5 

5 

8-10 

5 

4-6.6 

3-5 

7.5 

Steam  Engines 

3-10 

6.6 

5 

5-6.6 

5 

5 

4-6 

5 

2.5-5 

4-6.6 

5 

Steam  Turbines. . . 

5 

5 

s 

7-9 

5 

2.5-5 

4 

4 

Belted  Generators. . 

5-10 

6.6 

7.5 

5 

5 

5 

5-10 

5 

6.6 

3.3-4 

7.5 

Wires  and  Cables. 

2 

6.6 

5 

2 

S 

^ 

3-5 

5 

4-6.6 

5 

5 

Switchboard,  etc... 

'd 

6.6 

5 

2 

7.5 

5 

8-10 

5 

2-5 

5 

Motors 

5-10 

6.6 
6  6 

5 
10 

5 

5 

5 

5 

5 

5-8 
9-11 

5 
5 

4-6.6 
5-10 

5 
6.6 

5 

Storage  Batteries.. 

10 

Shop   Equipment . . 

3-10 

5 

7.5 

3.3-10 

7.5 

7.5 

12-15 

5 

4-10 

7.5 

'2  In  other  words,  normal  and  unavoidable  depreciation,  which  is 
measured  by  the  depreciation  reserve,  ranges  from  15  to  25  per  cent  of  original 
cost  of  machinery,  even  when  all  required  repairs  are  being  made.  For  a 
discussion  of  this  subject,  see  E.  A.  Saliers,  Principles  of  Depreciation. 


DEPRECIATION 


649 


Table  II 


Items  of  Equipment 

Boilers,  Water  Tube 

Boilers,  Fire  Tube 

Piping,  Steam  and  Water 

Auxiliaries,  Steam 

Engines,  Steam 

Turbines,  Steam 

Generators,    Belted • 

Wires  and  Cables 

Switchboards  and  Instru.Tjents 

Motors  (A.  C.  and  D.  C.) 

Sto.rage  Batteries 

Shop  Equipment,  Tools,  etc 


Light  or 

Intermittent 

Service 


Heavy  or 

Continuous 

Service 


4-6.6 
5-6.6 

4-5.5 

3-5 

4-5 

3-4 

4-6.6 

3-5 

2-5 

4-6.6 

5-6.6 

5-10 


5-8.3 

6.6-10 

5.5-8.3 

4-6.6 

5-6.6 

4-5 

5-8.3 

4-6.6 

5-8.3 

5-8.3 

6.6-10 

7.5-15 


Small  Tools 

Small  tools  should  be  revalued  periodically,  thus  fixing  ac- 
curately the  amount  of  depreciation.  If  this  plan  is  followed  for 
several  years  and  a  dependable  rate  is  secured,  it  may  be  feasible 
to  omit  the  revaluation  for  a  year  or  two,  applying  the  rate 
previously  ascertained. 

Furniture  and  Fixtures 

Many  concerns  write  down  this  item  to  $1.  The  practice  is  to 
be  commended  unless  stockholders,  partners,  or  other  interested 
parties  are  being  deceived.  If,  however,  this  asset  is  large,  such 
a  course  may  not  be  desirable;  yet  this  item  is  usually  overvalued 
so  far  as  any  actual  realization  of  its  book  value  is  concerned. 

Usually,  in  a  going  business,  assets  are  not  treated  on  the 
basis  of  realization  values;  but  in  the  case  of  furniture  and  fix- 
tures, so  many  changes  are  made  to  suit  the  convenience  and 
whims  of  executives  and  clerks,  and  offices  are  moved  so  often 
from  one  place  to  another,  that  furniture  and  fixtures  have  a 
very  indefinite  value. 

Office  partitions  are  frequently  built  at  the  expense  of  ten- 
ants and  are  worthless  at  the  end  of  the  lease.  In  the  meantime 
changes  are  often  made.  If  the  auditor  is  careful  he  may  fiild 
duplications  in  the  account. 

If  it  is  desirable  to  write  off  actual  or  realized  depreciation 
only,  15  per  cent  per  annum  is  a  fair  allowance  on  cost. 


650  AUDITING— GENERAL  PRINCIPLES 

Landlord's  Fixtures 

As  a  general  rule,  the  minimum  rate  of  depreciation  upon 
machinery  and  fittings  erected  upon  leasehold  property  should 
be  sufficient  to  wipe  off  the  book  value  before  the  expiration  of  the 
lease. '^ 

If  machinery,  etc.,  erected  on  leasehold  property  are  not  to 
become  landlord's  fixtures,  a  less  rate  may  be  appHed,  but  in  such 
case  there  should  be  a  definite  agreement  as  to  what  are  and 
what  are  not  to  be  the  landlord's  fixtures. 

Horses 

The  depreciation  of  horses  and  other  animals  is  rapid  and  in- 
evitable. The  rate  may  vary  from  15  to  25  per  cent  of  the  cost. 
By  means  of  revaluations,  which  can  be  more  accurately  made  in 
case  of  horses  than  of  most  other  assets,  the  actual  rate  of  depre- 
ciation should  soon  be  determined.  These  revaluations  should 
be  made  fairly  frequently. 

Wagons,  Automobiles,  etc. 

For  wagons,  from  8  to  10  per  cent  per  annum  is  an  ample 
allowance,  provided  that  all  repairs,  renewals  of  parts,  and  main- 
tenance are  charged  to  operating  expenses. 

As  with  wagons,  most  parts  of  automobiles  can  be  replaced. 
Under  ordinary  conditions  the  rate  of  depreciation  on  automobiles 
should  be  fixed  at  from  15  to  25  per  cent  per  annum.  The  most 
expensive  parts,  such  as  tires,  motors,  and  bodies,  are  easily 
replaced,  and,  if  charged  to  operating,  leave  unprovided  for  only 
accrued  depreciation  and  obsolescence. 

The  rate  for  taxicabs  is  stated  in  the  American  Institute 
Special  Bulletin  (September,  192 1),  to  be  ssH  P^r  cent  per 
aanum. 


^3  The  question  as  to  what  are  and  are  not  landlord's  fixtures  is  a  compli- 
cated one  which  cannot  be  taken  up  here.  The  legal  points  arising  in  con- 
nection with  them  are  considered  in  the  various  law  texts  which  treat  of  the 
relations  of  landlord  and  tenant. 


DEPRECIATION  651 

Ships 

Although  the  depreciation  of  ships  is  invariably  great  and 
must  be  the  subject  of  allowance,  it  is  difficult  to  determine  a 
fixed  rate.  The  amount  of  depreciation  should  be  certified  by 
an  engineer.  Unless  there  is  some  reason  for  doubting  the  cor- 
rectness of  his  report,  the  auditor  is  not  responsible. 

Rules  of  United  States  Treasury  Department. '^ — The 
Bureau  of  Internal  Revenue  of  the  Treasury  Department  has 
held  that  for  income  tax  purposes  3  per  cent  is  a  reasonable 
allowance  for  depreciation  of  bulk  freight  steamships  on  the 
Great  Lakes.  However,  if  it  can  be  shown  that  the  fixed  rate 
will  not  be  sufficient  to  return  all  the  capital  invested  by  the 
time  the  vessel  will  be  rendered  useless,  an  addition  to  the  regular 
rate  to  cover  obsolescence  may  be  allowed.'^ 

Depreciation  on  steam  schooners  engaged  in  the  coastwise 
lumber  trade  has  been  fixed  for  income  tax  purposes  at  5  per 
cent. '  ^ 

British  Practice. '^ — i,  xhe  normal  rates  of  allowance  for 
depreciation  are  as  follows  on  the  original  cost  price  of  the  vessel 
plus  subsequent  capital  expenditure:  on  steamers  4  per  cent;  on 
sailing  vessels  3  per  cent. 

Exceptional  cases  are  dealt  with  specially  by  the  commis- 
sioners concerned. 

2.  Allowances  are  made  year  by  year,  until  the  total  cost  of 
the  vessel,  less  the  breaking  up  value  (taken  at  the  rate  of  4  per 
cent  in  the  case  of  steamers  and  3  per  cent  in  the  case  of  sailing 
vessels),  has  been  allowed. 

3.  The  net  expenditure  on  the  renewal  of  engines  and  boilers 


'4  For  detailed  discussion,  see  Income  Tax  Procedure,  192 1,  page  894. 

's  Committee  on  Appeals  and  Review  Recommendation  27,  Cumulative 
Bulletin  Number  2,  Income  Tax  Rulings,  page  139. 

=  ^  Committee  on  Appeals  and  Review  Recommendation  279,  Cumulative 
Bulletin  Number  3,  Income  Tax  Rulings,  page  168. 

'7  See  Montgomery,  Income  Tax  Procedure,  1920,  page  733  et  seq.,  and 
Murray  and  Carter,  Income  Tax  Practice^  pages  252  et  seq.,  593,  594. 


652  AUDITING— GENERAL  PRINCIPLES 

and  the  net  cost  of  any  structural  improvements,  such  as  the 
lengthening  or  strengthening  of  a  ship,  is  not  allowed  as  a  de- 
duction for  income  tax  purposes,  but  is  added  to  the  prime  cost 
of  the  ship  and  depreciation  allowed  on  the  total  amount. 

4.  Where  a  vessel  changes  hands,  allowances  for  wear  and 
tear  are  granted  to  the  new  owner  not  exceeding  the  actual  cost 
to  him  of  the  vessel  (less  breaking  up  value) . 

The  usual  allowance  for  refrigerators  or  refrigerating  machin- 
ery is  understood  to  be  63^  per  cent  on  the  prime  cost;  for  oil 
tank  steamers  5  per  cent  on  prime  cost. 

Patents 

Although  some  value  may  attach  to  a  patented  article  after 
the  patent  has  expired,  it  is  generally  conceded  that  it  is  well  to 
write  off  the  entire  cost  of  a  patent  during  its  legal  life.  The 
patent  derives  its  value  in  great  measure  from  the  fact  that  it  is  a 
monopoly.  The  moment  the  monopoly  ceases  by  the  termina- 
tion of  patent  rights,  its  value  is  seriously  affected,  if  not  entirely 
wiped  out.  If  ^  patent  has  been  leased,  only  the  actual  cost 
thereof  in  fees,  etc.,  should  be  treated  as  an  asset.  To  capital- 
ize a  patent  lease  at  a  greater  sum  is  as  incorrect  as  to  capi- 
talize good-will,  although  both  are  latent  assets  in  every  paying 
concern. 

Copyrights  should  be  treated  similarly,  due  allowance  being 
made  for  the  fact  that  their  commercial  value  generally  expires 
long  before  the  termination  of  the  copyright. 

The  original  life  of  a  patent  is  seventeen  years.  Renewals 
are  dependent  upon  the  introduction  of  some  essential  novelty. 

For  purposes  of  the  income  tax  a  company  is  entitled  to 
deduct  as  expenses  the  costs  of  litigation  necessary  to  the  defense 
of  its  title  and  interest  in  a  patent. 

Good- Will 

Although  good-will  does  not  depreciate,  it  is  constantly  liable 
to  fluctuations.    Good-will  is  not  usually  written  ofif,  and  formerly 


DEPRECIATION  653 

the  question  of  the  amount  at  which  it  should  stand  in  the  bal- 
ance sheet  was  not  deemed  to  be  within  the  scope  of  the  auditor's 
work;  but  the  present  range  of  an  auditor's  duties  compels  him 
to  give  serious  thought  to  this  item.  The  valuation  of  good- will 
is  fully  discussed  on  pages  195-200.  This  discussion  should  be 
referred  to  if  any  question  arises  as  to  writing  off  all  or  any  part 
of  the  book  value  of  good- will. 

For  income  tax  purposes,  obsolescence  of  good- will  is  not 
ordinarily  applicable,  but  will  be  allowed  in  exceptional  cases, 
as  when  a  going  business  is  discontinued  because  of  the  exhaustion 
of  supply  sources;  providing,  of  course,  that  the  cost  of  the  good- 
will, or  its  fair  market  value  as  of  March  i,  19 13,  if  acquired 
prior  thereto,  can  be  definitely  shown,  and  providing  the  period 
of  obsolescence  can  be  determined  with  reasonable  accuracy.  ^  ^ 

Wasting  Assets 

These  will  be  considered  under  the  following  heads : 

Mines. — The  depreciation  of  mineral  wealth  through  ex- 
haustion resulting  from  exploitation  is  known  as  depletion.  The 
value  of  the  mine  to  the  owner  or  lessee  decreases  during  the 
year  by  exactly  the  amount  of  ore  extracted.  But  on  account 
of  the  uncertainty  in  the  total  amount  of  ore,  its  quality  and 
grade,  and  the  expense  which  may  be  involved  in  mining,  it  is 
difficult  to  fix  upon  a  rate  which  will  represent  the  average  deple- 
tion during  the  life  of  the  mine  or  the  term  of  the  lease,  as  the 
case  may  be.  This  can  be  done  only  by  estimation,  which  is 
naturally  inaccurate  and  may  be  misleading. 

Under  most  state  laws  a  mining  company  is  not  compelled  to 
write  off  any  depletion  before  declaring  a  dividend;  but  it  is 
generally  considered  better  finance  to  write  off  annually  such 
proportion  of  the  total  cost  of  plant  less  its  residual  value  as  the 
yearly  output  bears  to  the  estimated  content  of  the  mine,  or,  in 
case  of  a  leased  mine,  such  proportion  of  the  total  cost  of  the 


'8  Cumulative  Bulletin  Number  2,  page  141 ;  O.D.  472. 


654  AUDITING— GENERAL  PRINCIPLES 

lease  as  the  yearly  output  bears  to  the  output  estimated  for  the 
duration  of  the  lease. 

On  account  of  the  great  uncertainty  of  mining,  and  the  fact 
that  stockholders  object  to  the  accumulation  of  large  reserve 
funds,  which  can  earn  only  a  low  rate  of  interest  and  may  just, 
as  well  be  distributed  as  dividends,  it  may  be  better  policy  to 
regard  mines  as  temporary  undertakings  in  which  excesses  of 
current  revenue  may  be  distributed  without  regard  to  the  rela- 
tionship existing  between  the  value  of  the  remaining  assets  and 
the  amount  of  paid-up  capital. 

Timber  Lands 

Just  as  the  removal  of  a  ton  of  ore  or  coal  reduces  by  so  much 
the  value  of  a  mine,  so  the  cutting  of  each  thousand  feet  of  timber 
reduces  the  value  of  the  land  on  which  it  stood.  It  is  obvious 
that  there  should  be  written  off  from  year  to  year  such  propor- 
tion of  the  cost  of  the  lands  as  the  quantity  of  timber  cut  during 
the  year  bears  to  the  quantity  standing  on  the  entire  tract  at  the 
time  of  its  purchase. 

In  some  cases  allowance  for  the  value  of  the  cut-over  lands 
should  be  made  in  determining  the  amount  which  should  be 
charged  off  for  depletion  of  the  timber.  Very  frequently, 
however,  cut-over  land  has  but  little  value. 

Since  it  is  easier  to  determine  with  certainty  the  total  quantity 
of  timber  standing  on  a  tract  of  land  than  it  is  to  determine  the 
contents  of  a  mine,  it  follows  that  the  depletion  charge  per  thou- 
sand feet  of  timber  cut  can  be  more  accurately  fixed  than  can 
depletion  charges  in  mining  operations. 


CHAPTER   XXIX 

INTEREST 

The  professional  auditor  should  be  thoroughly  acquainted 
with  the  various  methods  of  calculating  interest.  There  is  a 
remarkable  lack  of  uniformity  among  business  houses,  and  even 
banks,  on  the  subject.  The  audit  clerk  who  verifies  interest  col- 
lections or  interest  payments  feels  relieved  if  his  own  calculation 
agrees  within  a  few  dollars  with  the  amount  received  or  paid  and 
lets  it  go  at  that. 

Since  the  ''few  dollars"  multiplied  a  number  of  times  aggre- 
gates a  considerable  sum,  it  is  important  that  the  auditor  famil- 
iarize himself  with,  and  require  his  clerks  to  learn,  the  laws  and 
customs  governing  interest,  so  that  when  a  test  is  made  it  will  be 
done  intelligently,  and  if  the  amount  received  is  insufficient  or  the 
amount  paid  is  excessive,  a  report  may  be  made  thereon  with 
confidence  in  the  correctness  of  the  criticism. 

The  three  factors  entering  into  the  calculation  of  interest  are 
principal,  rate,  and  time. 

Principal 

Principal  is  the  amount  on  which  interest  is  to  be  calculated. 
There  are  two  methods  of  reckoning  principal.  In  bank  discount 
the  principal  is  regarded  as  the  entire  face  of  the  note.  For  ex- 
ample, the  bank  discount  on  a  note  for  $i,ooo  payable  in  one  year 
at  6  per  cent  is  $60,  and  the  proceeds  paid  to  the  customer  are 
$940.  It  will  be  noted  that  here  the  customer  has  the  use  of  only 
$940  for  one  year,  and  yet  he  pays  interest  for  the  use  of  $1,000 
for  one  year.  The  actual  principal  on  which  interest  should  be 
chargeable  is  only  I940.  The  fictitious  principal,  on  which  inter- 
est actually  is  charged,  is  $1,000.  The  true  principal  in  such  case 
is  found  by  the  following  proposition: 

655 


656  AUDITING— GENERAL  PRINCIPLES 

1.06  :  i.oo   ::  $1,000   :  X 
which  gives  a  present  value  of  $943.40  for  X 

In  spite  of  the  foregoing  facts,  it  is  now  thoroughly  well 
settled  by  universal  usage  that  this  system  of  bank  discount  will 
be  permitted  by  the  courts,  even  though  it  does  actually  effectu- 
ate usury. 

The  right  is  expressly  given  to  national  banks  by  United  States 
Revised  Statutes,  Section  5197,  now  Section  5197  of  the  United 
States  Compiled  Statutes. 

The  right  is  also  given  to  New  York  banks  by  Section  74  of  the 
Banking  Law  of  that  state. 

But  the  practice  of  anticipating  the  interest  in  this  fashion  has 
been  held  not  to  authorize  the  charging  of  interest  on  the  antici- 
pated interest  in  case  such  interest  is  not  paid  at  the  date  of  the 
execution  of  the  note. 

In  the  case  of  First  National  Bank  v.  Davis,  ^  a  note  was  given 
for  $8,000  at  one  year  at  10  per  cent.  It  was  renewed  at  maturity. 
The  renewal  note,  instead  of  being  for  $8,800,  was  for  $8,880, 
made  up  as  follows:  $8,000  principal,  $800  anticipated  interest, 
and,  since  the  bank  did  not  receive  the  $800  anticipated  interest 
on  the  date  of  execution  of  the  renewal,  but  merely  took  the 
debtor's  promise  to  pay  the  $800  at  one  year,  the  bank  added  10 
per  cent  of  this  $800  (or  $80)  to  the  face  of  the  renewal  note,  mak- 
ing it  total  $8,880,  as  stated.    The  court  held  this  to  be  usury. 

Interest  in  Arrears. — The  question  of  principal  also  occurs 
when  payments  are  made  on  an  old  account  which  is  drawing 
interest.  Under  such  circumstances  the  debtor  sometimes  claims 
that  all  payments  should  apply  on  account  of  principal;  but  unless 
there  is  a  clear  and  specific  agreement  that  they  shall  be  so  ap- 
plied, the  rule  is  well  settled  that  such  payments  are  applicable 
in  the  first  instance  to  all  arrears  of  interest  before  any  application 
can  be  made  on  account  of  principal. 


108  111.  633  (Sup.  Ct.  111.,  1884). 


INTEREST  657' 

Compound  Interest. — The  question  of  principal  is  also  in- 
volved in  cases  dealing  with  compound  interest.  It  has  been  held 
that  interest  may  be  added  to,  and  become  a  part  of,  principal  at 
stated  times  and  under  certain  conditions,  and  the  question  of 
whether  or  not  this  is  permissible  sometimes  determines  whether 
or  not  the  transaction  is  usurious  or  otherwise.  This  is  a  point 
upon  which  an  auditor  is  frequently  required  to  pass. 

Loan  accounts  and  book  accounts  between  interrelated  enter- 
prises sometimes  run  along  for  years  without  a  final  settlement. 
When  a  statement  is  desired  upon  which  a  settlement  may  be 
based,  there  is  always  a  temptation  to  state  the  transactions  in  as 
short  rests  or  periods  as  possible,  the  interest  being  calculated  and 
included  in  each  balance  carried  forward.  This  results  in  com- 
pounding the  interest,  is  illegal,  and  should  never  be  permitted  by 
the  auditor. 

It  may  be  a  hardship  to  the  lender,  because  compound  interest 
would  be  legal  and  proper  in  such  a  case  if  the  accounts  had  been 
written  up  properly  at  the  time,  interest  actually  entered  in  the 
books,  and  statements  prepared  therefrom  and  submitted  to  the 
borrower  or  debtor.  If  not  objected  to  at  the  time  or  within  a 
reasonable  time  thereafter,  the  transaction  has  the  legal  effect  of 
an  account  stated,  and  each  new  starting  balance,  although  in- 
cluding interest  calculated  at  shorter  intervals  than  a  year,  being 
acquiesced  in,  is  binding. 

In  the  absence  of  special  custom  or  agreement,  however, 
interest  should  not  be  compounded. 

Rate  of  Interest 

This  rarely  or  never  admits  of  dispute  except  in  those  cases 
where  a  note,  contract,  bond,  or  other  obligation  is  made  in  one 
jurisdiction,  to  be  paid  or  performed  in  another  jurisdiction  with- 
out specifying  the  rate  of  interest,  and  the  legal  rate  of  interest 
in  the  two  jurisdictions  is  different.  Then  the  question  sometimes 
arises  whether  the  rate  at  the  place  of  making  the  note  or  the 
rate  at  the  place  of  payment  is  to  govern. 

VOL.  I — 42 


658  AUDITING— GENERAL  PRINCIPLES 

A  similar  question  arises  when  one  rate  of  interest  is  the 
legal  rate  at  the  time  of  making  the  note,  contract,  or  bond, 
and  another  legal  rate  is  in  force  when  the  obligation  falls 
due. 

In  the  absence  of  an  intention  to  the  contrary  shown  by  ex- 
press stipulation  or  otherwise,  the  rate  of  interest  is  to  be  regu- 
lated by  the  law  as  it  existed  at  the  time  and  place  of  making  the 
contract,  and  not  by  the  law  existing  when  the  debt  falls  due  or 
when  the  remedy  is  sought.^ 

It  is  well  settled,  however,  that  the  parties  may  contract  for 
the  legal  rate  in  either  place  and  the  contract  will  govern. 

Time 

The  time  for  which  interest  is  to  run  gives  rise  to  a  wide 
diversity  of  practice. 

There  is  an  underlying  principle  which  is  of  very  general, 
although  not  absolutely  universal,  appHcation,  and  it  is  this, 
that  if  the  first  day  of  the  interest  period  is  included  in  the  com- 
putation, then  the  last  day  shall  be  excluded ;  and  if  the  first  day 
is  excluded,  then  the  last  day  is  included.  The  parties  can,  if  they 
will,  contract  otherwise.  ^ 

Custom  in  Banks  and  Trust  Companies.— In  Kirkbride, 
Sterrett,  and  WiUis'  The  Modern  Trust  Company,"^  the  rule  is 
stated  to  be:  ^'  In  computing  interest  on  loans,  the  actual  number 
of  days  is  taken.  If  the  day  on  which  the  loan  was  made  is  in- 
cluded, the  day  of  payment  is  not  counted." 

It  is  more  or  less  common,  however,  for  banks  to  count  both 
the  first  and  last  days  when  the  interest  is  payable  to  themselves. 
This  custom  will  not  override  the  common  law  rule  unless  the 
parties  expressly  agree  to  it.  The  bank  that  figures  time  thus  at 
the  full  legal  rate  of  interest  in  the  state  of  Vermont  is  guilty  of 


2  8  Cyc.  310. 

3  See  Blanchard  v.  Hilliard,  1 1  Mass.  85. 

4  Fifth  edition,  page  125. 


INTEREST  659 

usury,  but  not  corrupt  usury.  ^  The  bank  that  does  this  same 
thing  in  the  state  of  Virginia  is  not  guilty  of  usury  at  all.  ^ 

In  the  Crump  case,  last  cited,  the  court  even  held  that  it  was 
proper  for  the  bank  to  charge  interest  not  only  on  the  first  and 
last  day  of  the  original  note,  but  also  on  the  first  and  last  day  of 
successive  renewal  notes,  the  result  being  that  the  bank  received 
double  interest  on  every  day  that  a  renewal  was  executed.  Many 
banks  follow  that  custom,  although  some  banks  are  content  with 
charging  the  first  and  last  day  on  the  original  note,  and  not  on  the 
renewal  note. 

The  legal  fiction  of  the  common  law  was  that  a  day  is  indivis- 
ible, and  therefore  even  if  a  customer  receives  his  discount 
money  just  before  closing  on  the  date  of  his  note,  and  pays  it 
immediately  after  opening  on  the  date  of  maturity,  he  still,  in 
strict  contemplation  of  law,  has  had  the  use  of  that  money  all  of 
both  the  terminal  days,  and  on  that  fiction  the  decision  in  the 
Crump  case  was  undoubtedly  sound  law.  Whether  it  was  equit- 
able or  not  is  another  question. 

When  Interest  Is  Paid.— Where  banks,  however,  have  to  pay 
interest,  instead  of  receive  it,  they  apply  a  widely  different  rule. 

1.  Quite  generally  they  credit  interest  on  deposits  only  the 
day  after  deposit,  on  the  theory  that  most  deposits  are  made  by 
cheque  and  it  takes  one  day  on  an  average  to  collect  through  the 
clearing  house. 

2.  Some  banks  provide  that  deposits  made  between  the 
second  and  the  fifteenth  of  the  month  shall  draw  interest  from 
the  fifteenth;  and  that  deposits  made  between  the  sixteenth  and 
the  first  of  the  following  month  shall  draw  interest  from  the  latter 
date. 

Assuming  a  uniform  volume  of  deposits  for  each  day  of  the 
month,  this  arrangement  is  advantageous  to  the  bank  as  against 
its  depositors  in  the  ratio  of  2  to  i . 


s  Bank  of  Burlington  v.  Durkee,  i  Vt.  399. 

<»  Crump  V.  Trytitle,  5  Leigh  251  (Court  of  Appeals  of  Virginia,  1834) 


66o  AUDITING— GENERAL  PRINCIPLES 

3.  Savings  banks  quite  generally  provide  that  deposits  made 
between  the  first  and  fifth  day  of  the  month  shall  draw  interest 
from  the  first,  while  deposits  made  after  the  fifth  shall  draw  inter- 
est from  the  first  day  of  the  following  month. 

Assuming  a  uniform  volume  of  deposits  for  each  day  of  the 
month,  this  arrangement  is  to  the  advantage  of  the  bank  as 
against  its  depositors  in  the  ratio  of  5  to  i . 

4.  Some  banks  allow  interest  on  savings  accounts  only  by 
full  calendar  months. 

5.  Some  banks  provide  that  if  the  depositor  makes  a  with- 
drawal during  any  semiannual  interest  period,  he  thereby  loses 
all  interest  which  may  have  accrued  thereon  since  the  last  interest 
date. 

This  rule  works  largely  to  the  profit  of  the  banks  and  to  the 
loss  of  the  depositors. 

Ignorance  of  Customers. — As  to  how  far  an  auditor  may 
wish  to  criticize  these  rules  is  a  question  for  individual  determina- 
tion. The  fact  is,  however,  that  most  business  men  know  nothing 
about  the  customs  with  respect  to  interest.  They  can  negotiate 
for  a  low  rate  of  interest  on  loans  or  a  high  rate  on  deposits,  but 
they  do  not  know  that  their  bank  may  have  estabhshed  arbitrary 
interest  rules  which  yield  them  a  greater  profit  than  other  banks 
exact.  It  may  therefore  be  proper  for  the  auditor  to  examine 
into  the  whole  matter  and  report  thereon  to  the  cKent. 

Custom  Among  Business  Houses. — Business  and  com- 
mercial houses  as  a  rule  count  only  the  first  or  last  day,  but  not 
both,  when  they  figure  interest. 

Custom  Among  Stock-Brokers. — Stock-brokers  settle  pur- 
chases the  day  following  the  sale,  and  they  debit  the  customer's 
account  on  the  day  of  settlement.  In  charging  monthly  interest 
to  the  customer,  the  broker  includes  both  the  day  of  settlement 
and  the  last  day  of  the  month.  The  broker  justifies  this  by 
showing  that  he,  in  turn,  is  compelled  to  pay  interest  on  his  loan 


INTEREST  66l 

to  the  bank  in  like  manner  by  including  both  the  terminal  days 
of  the  period  in  his  calculation. 

The  stock-broker,  by  rendering  accounts  monthly  and  cal- 
culating interest  for  the  same  period,  compounds  the  interest 
monthly. 

New  York  Clearing  House.— In  its  official  annoimce- 
ments,  the  New  York  Clearing  House  includes  the  first  day  and 
excludes  the  last  day. 

New  York  Stock  Exchange  Practice. — The  New  York 
Stock  Exchange  regulations  require  that: 

Interest  on  bonds  shall  be  computed  for  the  number  of  months 
and  days  elapsed  from  the  last  previous  coupon  date  to  date  of 
delivery,  but  not  including  both  the  coupon  date  and  the  date  of 
delivery.  The  computation  shall  be  based  on  a  table  counting 
three  hundred  and  sixty  (360)  days  to  the  year. 

Every  calendar  month  is  1/12  of  360  days — 30  days. 

Every  period  from  a  date  in  one  month  to  the  same  date  in 
the  following  month  is  30  days. 

To  all  bond  quotations  add  accrued  interest,  excepting  bonds 
in  default  and  income  bonds,  both  of  these  classes  of  bonds  being 
sold  ^^flat." 

In  settlement  of  contracts  in  interest-paying  bonds  the  "interest" 
shall  be  computed  to  the  day  of  maturity  of  contract  on  regular  sales  or  on 
sales  at  three  days,  at  the  rate  specified  in  the  bond;  and  on  time  option 
contracts,  interest  specified  in  the  bond  shall  be  computed  to  include  the 
day  of  sale,  and  thereafter  at  the  rate  of  interest  agreed  upon. 

Registered  bonds  will  not  sell  ex-interest  on  the  day  the  books  close  for 
payment  of  interest.  In  settlement  of  contracts  in  interest-paying  regis- 
tered bonds,  interest  must  be  added  to  the  date  of  the  maturity  of  contract, 
and  a  due  bill,  signed  by  the  party  in  whose  name  the  bond  stands  for  the 
full  amount  of  the  interest  to  be  paid  by  the  company,  must  accompany 
the  bond  until  interest  is  paid;  the  due  bill  issued  by  a  non-member  must 
be  paid  when  due  by  the  Exchange  member  or  firm  guaranteeing  it. 

The  Treasury  Department  of  the  United  States. — In 
the  Treasury  Department  it  is  provided  that:  ''Only  one  of  the 


662  AUDITING— GENERAL  PRINCIPLES 

two  days  of  date  and  due  date  of  an  obligation  is  taken  into 
account  in  stating  the  time  for  which  interest  is  to  be  calculated." 

The  Unit  Period 

Interest,  either  expressly  or  impliedly,  is  at  such  a  rate  "per 
annum." 

Where  the  interest  runs  for  one  month,  quarterly,  or  semi- 
annually, the  proportion  is  one-twelfth,  one-fourth,  or  one-half 
of  a  year. 

A  month  is  held  to  be  one-twelfth  of  the  year,  no  matter 
whether  the  month  have  twenty-eight,  twenty-nine,  thirty,  or 
thirty-one  days. 

Both  of  the  foregoing  rules  are  in  force  universally  and  are 
sanctioned  by  the  rules  of  the  United  States  Treasury  Depart- 
ment. 

Where  the  interest  runs,  however,  for  so  many  days,  there  is 
a  sharp  diversity  of  opinion  as  to  whether  a  calendar  year  of  365 
days  (366  days  for  a  leap  year)  or  an  artificial  year  of  360  days 
is  the  proper  unit  of  calculation. 

The  New  York  Clearing  House  calculates  interest  on  the 
basis  of  360  days  to  a  year.  For  instance,  the  interest  on  $1,000 
from  January  i,  191 2,  to  March  12,1912,  at  4  per  cent  per  annum 
was  officially  calculated  as  $7.89.  This  represented  71  days  on  a 
360-day-to-the-year  basis. 

It  has  also  been  held  by  the  courts  that  the  artificial  year  of 
360  days  is  a  proper  basis.  "^ 

But  the  better  rule,  at  least  in  modern  times,  would  seem  to  be 
that  the  calendar  year  of  365  days  is  the  proper  basis. 

A^.  F.  Firemen  Ins.  Co.  v.  Ely^  held  that  taking  interest  on  the 
basis  of  360  days  to  the  year  was  usury. 

Chapter  148  of  the  Acts  of  Massachusetts  of  1909,  approved 
March  6,  1909,  entitled  "An  Act  Relative  to  the  Computation  of 


V  State  Bank  of  North  Carolina  v.  Cowan,  8  Leigh  238  (Court  of  Appeals  of 
Virginia,  1837). 


«  2  Cowen  678  (Supreme  Court  of  New  York,  1824). 


INTEREST  663 

Interest  on  Bonds  and  Notes  in  Dealings  with  the  Common- 
wealth," makes  the  year  of  365  days  the  standard  for  all  loans  to 
or  by  the  commonwealth. 

New  York  Law. — After  many  vicissitudes,  the  state  of  New 
York  now  has  in  force  the  following  r^ 

The  term  year  in  a  statute,  contract,  or  any  public  or  private  instru- 
ment, means  365  days,  but  the  added  day  of  a  leap  year  and  the  day  imme- 
diately preceding  shall  for  the  purpose  of  such  computation,  be  counted  as 
one  day  .  .  .  the  term  year  means  twelve  months,  the  term  half  year,  six 
months,  and  the  term  quarter  of  a  year,  three  months. 

Rules  of  U.  S.  Treasury. — The  rules  of  the  Treasury  De- 
partment of  the  United  States  government  are  as  follows: 

In  calculating  interest  for  a  fractional  period,  the  time  is  the  true 
fraction  of  that  period.  For  an  annual  rate,  the  time  is  the  exact  number 
of  days  for  which  the  interest  runs  divided  by  the  number  of  days  in  the 
year,  365  or  366;  for  a  semiannual  or  quarterly  period,  it  is  the  number  of 
days  for  which  the  interest  runs  divided  by  the  number  of  days  in  the 
particular  half  year  or  quarter  year. 

Unless  the  unit  period  is  a  month,  the  month  does  not  enter  into  interest 
computations,  only  days  and  the  full  unit  period  being  considered. 

Bonds  and  Mortgages. — The  rule  just  enunciated  is  some- 
what at  variance  with  the  rule  generally  obtaining  on  bonds  or 
mortgages  on  which  the  interest  accrues  regularly,  as  for  example, 
quarterly  or  semiannually.  There,  when  interest  is  computed  for 
a  part  of  such  quarterly  or  semiannual  period,  it  is  the  usual 
custom  to  state  the  time  in  months  and  days  rather  than  entirely 
in  days.  In  such  a  calculation  the  number  of  full  months  from  the 
initial  date  to  the  same  numbered  day  of  the  month  next  preced- 
ing the  final  date  should  first  be  ascertained,  and  then  the  odd 
days  to  the  final  date. 

When  we  figure  these  odd  days,  there  are  three  ways  of  mak- 
ing the  computation. 


Sec.  58  of  the  General  Construction  Law  of  New  York. 


664  AUDITING— GENERAL  PRINCIPLES 

1.  They  may  be  taken  at  so  many  thirtieths  of  a  month  (on 

the  360-day  basis). 

2.  They  may  be  taken  as  so  many  twenty-eighths,  twenty- 

ninths,   thirtieths,   or   thirty-firsts,   according  to  the 
month  in  which  they  fall. 

3.  They  may  be  taken  as  so  many  three  hundred  and  sixty- 

fifths  of  a  year. 

It  is  not  assumed  by  any  means  that  the  foregoing  discussion 
covers  the  question  of  interest  at  all  exhaustively,  but  the  author 
hopes  that  the  customs  and  decisions  reviewed  will  enable  a 
student  or  practitioner  to  substantiate  any  criticisms  which  he 
may  deem  proper  to  make  during  the  progress  of  an  audit. 


CHAPTER  XXX 

THE  LIABILITIES  OF  DIRECTORS 

It  may  be  thought  that  the  duties  and  responsibilities  of  an 
auditor  are  onerous  enough  without  injecting  into  a  treatise  of 
this  nature  an  intimation  that  a  professional  auditor  is  charged 
with  looking  after  the  directors  of  a  corporation  as  well  as  its 
officers  and  clerks. 

Such  is  rarely  the  case,  however,  because  most  of  the  direc- 
tors in  the  United  States  who  direct  and  who  perform  acts  which 
require  review,  are  officers  as  well,  and  the  auditor  examines  their 
transactions  as  such  and  not  in  their  capacity  as  directors. 

Board  Minutes'  Inspection 

Nevertheless,  the  auditor  may  find,  in  reading  the  minutes 
of  the  proceedings  of  the  board  of  directors  or  of  an  executive  or 
other  committee,  that  one  or  more  directors  have  been  intrusted 
with  negotiations  to  purchase  property  or  with  similar  commis- 
sions. In  such  cases  the  auditor  should  verify  the  transaction 
along  the  usual  lines. 

Directors'  Dealings  with  Company 

If  a  director  receives  no  compensation,  except  perhaps  a 
small  attendance  fee,  the  warning  as  to  participation  in  meetings 
is  not  so  pertinent,  but  it  frequently  happens  that  directors  are 
interested  in  contracts  and  other  transactions  which  are  author- 
ized or  arranged  at  meetings  in  which  they  participate. 

If  the  auditor  discovers  this  state  of  affairs  and  is  convinced  of 
the  bona  fides  of  the  transactions,  he  need  not  criticize,  but  he  can 
point  out  the  divergence  from  the  law,  state  the  proper  procedure, 
and  suggest  that  at  the  next  meeting  of  stockholders  all  such 
questionable  acts  of  the  directors  be  ratified. 

665 


666  AUDITING— GENERAL  PRINCIPLES 

Under  ordinary  circumstances  a  director  is  held  responsible 
for  good  faith  only,  but  if  the  minutes  are  not  full  and  clear  and 
at  some  distant  day  a  dissatisfied  stockholder  or  creditor  looks 
sharply  for  unlawful  and  unauthorized  transactions,  the  director 
may  find  himself  involved  in  annoying,  if  not  expensive,  litigation. 

In  one  case  the  directors  in  the  name  of  the  corporation  pub- 
lished a  libel  on  one  of  their  number,  the  treasurer  (Hill).  The 
latter  sued  the  corporation  and  recovered  a  substantial  sum. 
He  sued  the  directors  individually  and  recovered  damages  from 
them.  Then  the  corporation  sued  the  directors  due  to  losses  it 
suffered  through  the  misconduct  of  the  defendants.  The  court 
ruled  that  the  directors  were  liable.' 

Personal  Liability  of  Directors 

Section  i6  of  the  Illinois  Corporation  Act  provides: 

If  the  indebtedness  of  any  stock  corporation  shall  exceed  the  amount 
of  its  capital  stock,  the  directors  and  officers  of  such  corporation,  assenting 
thereto,  shall  be  personally  and  individually  liable  for  such  excess,  to  the 
creditors  of  such  corporation. 

Under  this  law  a  case  arose  in  which  a  creditor  agreed  not  to 
hold  the  directors  personally  liable  for  notes  he  had  accepted 
from  the  corporation.  The  directors  were  considered  personally 
liable  even  though  as  directors  they  did  not  sign  the  notes  which 
had  created  a  debt  in  excess  of  amount  of  the  capital  stock  of  the 
corporation.  "^ 

The  court  held  when  the  directors  authorized  debts  in  excess 
of  the  capital  stock,  they  became  sureties  for  the  excess,  regard- 
less of  whether  they  signed  the  notes  or  not. 

Compensation  of  Directors 

Directors  usually  receive  an  attendance  fee  ranging  from  $5 
to  $50,  and  so  long  as  there  is  nothing  in  the  by-laws  to  prevent, 
the  auditor  can  accept  as  authority  therefor  a  resolution  which 


'  Hilletal.v.  Murphy  etal.,()8N. E.  (Mass.)  781. 
^  Slater  v.  Taylor,  146  111.  App.  97. 


'  THE  LIABILITIES  OF  DIRECTORS  667 

has  been  regularly  adopted.  The  minutes  should  record  the 
names  of  all  directors  present  at  each  meeting,  which  serves  as  a 
check  on  the  amount  disbursed  for  this  purpose.  Compensation 
in  excess  of  the  attendance  fee  is  rarely  paid  to  a  director  who  is 
not  an  officer. 

If  any  sum  is  voted  to  one  or  more  directors,  the  auditor 
should  ascertain  whether  the  by-laws  permit  the  payment,  and 
whether  the  action  was  taken  at  a  full  board  meeting  or  whether 
any  were  absent  who  might  have  objected.  If  any  director  who 
is  benefited  votes  for  the  resolution,  or  if  his  presence  is  necessary 
to  make  a  quorum,  the  action  is  voidable  and  may  be  attacked. 
■  All  such  transactions  should  be  reported  to  and  ratified  by  the 
annual  meeting  of  stockholders.  If  no  such  action  has  been  taken 
by  the  stockholders,  the  auditor  should  mention  the  fact  in  his 
report. 

It  has  been  held  by  the  courts  that  officers  are  not  entitled  to 
compensation  simply  because  they  occupy  office  and  perform  the 
duties  incident  thereto.  Their  salaries  should  be  fixed  before 
election  as  directors,  if  possible.  If  this  is  not  feasible,  the 
amounts  paid  to  the  directors  in  compensation  for  their  services 
should  be  reported  to  the  annual  meeting  and  be  formally  ap- 
proved by  the  stockholders. 

As  a  practical  matter,  where  the  officers  and  directors  own  all 
or  nearly  all  of  the  stock  and  are  acting  in  good  faith,  it  is  not 
necessary  to  report  salaries  or  other  matters  of  detail  to  the 
stockholders'  meeting. 

Directors  May  Inspect  Books 

It  is  not  generally  known  that  a  director  has  an  absolute  right 
to  inspect  the  books  and  papers  of  a  corporation  of  which  he  is  a 
director.  There  are  a  great  many  men  who  represent  minority 
interests  on  a  board  and  who  are  almost  totally  ignored  in  the 
management  of  the  company.  Information  with  respect  to 
finances  or  earnings  is  rarely  furnished  to  them,  and  is  then 
handed  out  as  if  there  were  no  obligation  to  do  so. 


668  AUDITING— GENERAL  PRINCIPLES 

Auditors  are  frequently  consulted  by  directors  who  state  that 
they  have  tried  to  secure  information  without  success.  The 
auditor  should  advise  them  that  their  legal  right  to  full  access  to 
the  books  is  unquestioned,  and  that  they  may  be  accompanied 
by  a  professional  auditor  if  they  require  assistance.  Directors 
are  charged  with  a  knowledge  of  what  is  going  on,  and  if  they  fail 
to  keep  informed,  they  may  be  held  jointly  responsible  for  the 
acts  of  others.  In  all  cases,  therefore,  in  which  they  have  any 
doubt  as  to  what  is  going  on,  it  is  nothing  more  than  simple  busi- 
ness prudence  to  employ  an  auditor  who  will  ascertain  exact 
conditions. 

Unless  there  is  a  specific  inhibition  which  the  auditor  on 
moral  or  legal  grounds  believes  to  be  binding  upon  him,  he  should 
so  far  as  possible,  report  to  members  of  the  board  of  directors 
individually,  and  it  is  not  improper  for  him  so  to  word  his  report 
as  to  invite  personal  conferences  with  any  or  all  of  them. 

A  director  has  a  right  to  inspect  all  of  the  books  and  papers  of 
a  company.  This  includes  the  auditor's  report,  and  if  an  auditor 
has  reason  to  believe  that  any  director  does  not  receive  his  report, 
he  should  investigate  and  at  least  ascertain  whether  the  director 
is  knowingly  ignorant  or  whether  he  is  kept  in  ignorance  of  the 
existence  of  the  auditor's  report  because  the  officers  or  his  col- 
leagues have  something  to  conceal.  Many  directors  do  not  know 
that  under  certain  conditions  they  are  personally  liable  for  all 
debts  in  excess  of  a  certain  amount.  The  auditor  should  post 
himself  on  this  and  other  points  so  as  to  be  able  to  make  helpful 
suggestions. 

Rulings  Cited. — The  directors'  right  to  examine  the  books 
of  a  corporation  and  the  extent  to  which  he  may  be  assisted  by 
public  accountants,  is  brought  out  in  quotations  from  the  rulings 
which  follow: 

A  director  of  a  domestic  corporation  doing  business  in  the  city  of  New 
York  is  entitled,  as  a  matter  of  law,  to  a  peremptory  writ  of  mandamus 
requiring  the  president  and  treasurer  of  such  corporation  to  exhibit  to  him 


THE  LIABILITIES  OF  DIRECTORS  669 

the  books  and  papers  of  the  corporation  for  examination  by  himself,  alone 
or  with  the  aid  of  a  competent  and  proper  person  employed  by  him  and 
approved  by  the  court. 

An  order  granting  such  an  application  which  allows  the  director,  his 
attorney,  accountant  and  assistants,  without  limitation  in  number,  to  ex- 
amine the  books,  and  permits  the  examination  to  range  over  a  period  of 
three  months,  is  too  broad  in  its  scope,  where  it  does  not  appear  that  more 
than  one  accountant  will  be  required  or  that  the  examination  will  take 
three  months. 

Such  an  order  should  be  modified  by  allowing  the  examination  and  the 
inspection  to  be  made  by  the  director  and  one  accountant,  and  the  period 
within  which  the  examination  should  be  made  should  be  limited  to  four 
weeks  with  a  provision  allowing  an  application  to  the  court  for  an  exten- 
sion of  the  time  in  ca*Se  of  necessity.  ^ 

.  .  .  the  right  of  a  director  to  such  inspection  is  absolute,  being  neces- 
sary to  enable  him  to  perform  the  duties  of  his  office.  To  enable  a  director 
to  secure  such  inspection  he  need  only  show  that  he  is  a  director  and  has 
demanded  permission  to  examine  the  books  and  has  been  refused."* 

Directors  Cannot  Confer  Unlimited  Rights  Upon 
Auditors. — Although  the  director's  right  to  examine  the  books 
of  the  corporation  is  absolute,  he  cannot  confer  unlimited  rights 
of  inspection  upon  auditors. 

Although  a  director  of  a  corporation  may  be  aided  by  an  accountant  or 
an  attorney  in  making  an  inspection  and  examination  of  the  corporate 
books,  where  its  accounts  are  intricate  and  complicated,  he  cannot  entirely 
delegate  this  duty  to  professional  accountants. 

Hence,  the  mere  fact  that  a  corporation  has  closed  its  town  office  and 
removed  its  books  to  another  office  about  twenty  miles  distant,  does  not 
authorize  a  director  to  delegate  his  official  right  and  duty,  as  such,  to  an 
audit  company,  and  to  subject  the  corporate  books  to  an  unlimited  ex- 
amination by  such  company's  employees.  ^ 

Director's  Duty  to  Inspect  Books. — Not  only  does  the 
director  have  the  right  to  inspect  the  books  of  the  corporation; 

3  People  ex  rel.  Mclnnes  v.  Columbia  Bag  Co.,  103  App.  Div.  208  (April, 
1905). 

^People  ex  rel.  Leach  v.  Central  Fish  Co.,  117  App.  Div.  77  (January  11, 
1907). 

s  People  ex  rel.  Bartels  v.  Borgstede,  as  President  of  the  Ferncliff  Cemetery 
Assn.f  etc.,  169  App.  Div.  421  (October  22,  1915). 


670  AUDITING— GENERAL  PRINCIPLES 

it  is  his  duty  to  do  so,  because  he  cannot  otherwise  act  intelli- 
gently in  determining  the  financial  policy  of  the  corporation. 
The  law  of  New  York  State  provides  that  the  directors  of  a  stock 
corporation  shall  not  declare  dividends  except  from  "surplus 
profits  arising  from  the  business  of  such  corporation, "  also  that 
they  shall  not  in  any  way  pay  to  stockholders  "any  part  of  the 
capital  of  such  corporation"  except  as  authorized  by  law.  If  a 
director  wishes  to  act  intelligently  regarding  such  problems  as 
these,  he  will  regard  inspection  of  the  books  of  his  corporation  as  a 
duty  as  well  as  a  right. 

Legal  Liabilities  of  Directors 

It  is  unquestionably  the  duty  of  a  professional  auditor  to 
warn  the  directors  against  the  payment  of  unearned  divi- 
dends. If  it  appears  that  his  suggestion  is  unheeded  it  may 
be  that  he  has  fully  discharged  his  duty,  but  in  view  of  pos- 
sible subsequent  developments  the  auditor  should  seek  legal 
advice  in  order  to  be  sure  that  his  own  position  is  unassailable. 
The  report  and  certificate  will,  of  course,  set  forth  his  position 
fully. 

Successful  business  men  might  look  with  more  favor  upon 
directorships  if  they  were  sure  that  affairs  of  the  corporation 
would  have  the  periodical  supervision  of  auditors  who  seek  to 
broaden,  rather  than  to  narrow,  their  responsibiHties. 

American  Malting  Case. — The  auditor's  consideration  of 
the  possible  legal  liabilities  of  directors  need  not  extend  beyond 
matters  connected  with  the  accounts,  but,  wherever  accounting 
questions  are  involved,  the  auditor's  familiarity  therewith  should 
be  unquestioned.  In  the  American  Malting  case,^  decided  in 
New  York  in  1904,  the  court  discussed  the  relation  and  duties  of 
directors  to  the  accounts.  The  decision  is  of  sufiicient  interest  to 
warrant  its  reproduction  in  full: 


6  92  N.Y.S.  70;  45  Misc.  Rep.  484. 


THE  LIABILITIES  OF  DIRECTORS  67 1 

Archibald  A.  Hutchinson  and  Victor  K.  McElheny,  Jr., 
on  Behalf  of  Themselves  and  All  Other  Stockholders  of 
the  American  Malting  Co.,  Similarly  Situated, 

Plaintifs, 

V. 

Alexander  M.  Curtiss  and  the  American  Malting  Co., 

Defendants. 

(Supreme  Court,  New  York  Special  Term,  December,  1904.) 

The  statutes  of  this  State  allow  the  recovery,  from  directors  of  a  foreign 
corporation,  of  dividends  unauthorized  by  the  laws  under  which  such  cor- 
poration is  organized.  It  is  the  foreign  statute  that  makes  the  dividends 
unauthorized  but  the  recovery  is  to  be  had  under  the  New  York  statute. 

No  dividends  can  be  made  except  from  ''surplus  or  net  profits." 

Contracts,  entered  into  by  a  corporation,  for  future  deliveries  of  a 
product  not  yet  made  by  it,  from  raw  material  not  yet  purchased,  cannot 
be  taken  as  assets  in  figuring  said  surplus  or  net  profits.  Dividends  cannot 
be  made  on  a  mere  hope  or  expectation  of  profits. 

Where  raw  material  is  bought  by  weight  and  after  manufacture  is 
increased  in  weight  and  value,  the  corporation  is  entitled  to  treat  it  as  an 
asset  at  its  increased  value. 

A  director,  who  is  not  present  when  an  unauthorized  dividend  is  de- 
clared, is  not  liable  under  the  statute,  even  though  he  is  present  at  a  subse- 
quent meeting  when  the  minutes  of  the  former  meeting  are  ratified. 

A  director,  sued  for  unauthorized  dividends,  cannot  be  credited  with 
the  profits  which  subsequently  accrued  under  a  change  of  management. 

A  director  is  not  liable  for  commissions,  paid  on  the  sale  of  bonds  of  a 
corporation  which  had  made  unauthorized  dividends,  in  the  absence  of 
proof  of  fraud  and  conspiracy  for  the  defendant's  personal  benefit;  such 
loss  is  included  in  the  loss  caused  by  the  illegal  dividends  which  defendant 
must  pay. 

Action  against  director  for  making  unauthorized  dividends. 

Clarke  J.: 

The  American  Malting  Company  was  organized  under  the  laws  of 
New  Jersey,  September  28,  1897.  It  began  business  on  October  11,  1897. 
On  October  15, 1897,  it  filed  a  copy  of  its  charter  in  the  office  of  the  Secre- 
tary of  State  of  New  York  to  enable  it  to  do  business  in  this  State  and 
received  the  usual  certificate  for  that  purpose.    The  principal  office  of  the 


672  AUDITING— GENERAL  PRINCIPLES 

company  was  situated  in  the  city  of  New  York,  at  No.  80  Broadway,  from 
its  organization  until  the  fall  of  1899,  and  since  then  it  has  been  situated 
continuously  at  East  River  and  Sixty-third  Street,  New  York  City.  The 
company  has  had  no  plant  or  property  in  New  Jersey.  It  has  kept  no  bank 
account  there.  It  had  merely  a  formal,  statutory  office  in  that  State.  Its 
capital  stock  is  $30,000,000,  divided  into  300,000  shares  of  $100  each,  of 
which  144,400  shares  of  preferred  stock  and  145,000  shares  of  common 
stock  have  been  issued.  The  preferred  stock  is  seven  per  cent  cumulative, 
having  a  preference  as  to  dividends  only.  The  company  is  engaged  in  the 
manufacture  and  sale  of  malt.  Its  stock  was  issued  to  promoters  for 
twenty-one  malting  estabHshments,  situated  in  various  parts  of  the  United 
States,  on  which  they  had  acquired  options,  and  for  $2,080,000  cash  work- 
ing capital.  No  stock  in  trade  was,  however,  acquired  by  the  issue  of 
stock.  As  soon  as  the  organization  was  effected  the  company  was  com- 
pelled to  purchase  from  the  vendors  of  the  various  malting  plants  their 
stocks  of  barley  and  malt,  for  which  the  company  issued  its  obligations, 
amounting  to  upward  of  $1,600,000.  A  little  over  two  months  after  the 
company  began  business,  and  on  December  20, 1897,  the  board  of  directors 
declared  a  dividend  of  one  and  three-fourths  per  cent  to  preferred  stock- 
holders, payable  January  15,  1898.  This  amounted  to  $219,450.  There- 
after a  dividend  at  the  same  rate  was  declared  and  made  payable  at  each 
of  the  following  dates:  April  15,  1898,  $219,450;  July  15,  1898,  $219,450; 
October  15,  1898,  $219,450;  January  15,  1899,  $219,450;  April  15,  1899, 
$252,700;  July  15,  1899,  $252,700;  October  15,  1899,  $252,700.  In  all 
$1,855,350.  Barely  two  weeks  after  the  payment  of  the  dividend  of  Octo- 
ber 15, 1899,  and  on  November  2, 1899,  the  minutes  of  the  board  of  direct- 
ors disclosed  its  serious  financial  condition  as  reported  to  said  board,  viz., 
its  outstanding  obligations  amounted  to  $2,800,000  in  notes;  that  the 
officers  were  unable  to  negotiate  further  temporary  loans;  that  the  com- 
pany needed  additional  working  capital,  and  that  the  board  authorized  the 
sale  of  $4,000,000  mortgage  bonds  of  the  company.  Said  bonds,  six  per 
cent  fifteen-year  gold  mortgage  bonds,  were  subsequently  disposed  of  at  a 
discount  of  $400,000.  This  is  an  action  brought  by  plaintiffs  as  stock- 
holders on  behalf  of  themselves  and  all  other  stockholders  similarly 
situated  against  the  defendant  Curtiss  as  director  of  the  company  to  com- 
pel him  to  account  for  and  pay  to  the  company  the  amount  of  the  dividends 
declared  and  paid  as  not  having  been  paid  out  of  the  profits,  but  out  of  the 
capital.  The  board  of  directors  having  upon  demand  refused  or  neglected 
to  bring  suit  in  the  name  of  the  company,  it  was  joined  as  a  party  defendant. 
At  first  the  company  put  in  a  defense,  but  subsequently,  its  management 
having  changed,  it  obtained  leave  to  file  an  amended  answer  admitting  the 


THE  LIABILITIES  OF  DIRECTORS  673 

allegations  of  the  complaint  and  joining  in  the  prayer  of  the  plaintiffs  for 
the  relief  demanded.  In  a  similar  action  against  another  of  the  directors 
the  complaint  was  dismissed  upon  the  trial.  Upon  appeal  the  Appellate 
Division  reversed  that  judgment.  Hutchinson  v.  Stadler,  85  App.  Div. 
428.  That  case  settled  the  law  for  this  court  to  this  extent ;  that  an  action 
could  be  maintained  in  the  courts  of  this  State  against  a  director  of  a  New 
Jersey  corporation  to  recover  the  amount  of  dividends  declared  in  violation 
of  the  laws  of  that  State.  Two  opinions  were  handed  down,  in  which  the 
learned  justices  arrived  at  the  conclusion  that  the  action  could  be  main- 
tained upon  different  grounds.  With  each  of  these  opinions  a  justice 
concurred.  The  fifth  learned  justice  concurred  in  the  result.  I  cite  this 
division  of  opinion  because  this  court  is  now  called  upon  to  apply  the  law, 
as  laid  down  with  this  practical  embarrassment,  that  while  it  was  the 
unanimous  decision  that  the  action  could  be  maintained,  yet  the  difference 
in  the  grounds  therefor  means  a  difference  of  hundreds  of  thousands  of 
dollars  in  the  judgment  I  am  about  to  order.  As  I  interpret  it  that  case 
holds  this  court  has  jurisdiction,  because  section  twenty-three  of  the  Stock 
Corporation  Law  of  this  State  provides:  "The  directors  of  a  stock  cor- 
poration shall  not  make  dividends,  dxcept  from  the  surplus  profits  arising 
from  the  business  of  such  corporation;  nor  divide,  withdraw  or  in  any  way 
pay  to  the  stockholders,  or  any  of  them,  any  part  of  the  capital  of  such 
corporation,  or  reduce  its  capital  stock,  except  as  authorized  by  law.  In 
case  of  any  violation  of  the  provisions  of  this  section,  the  directors  under 
whose  administration  the  same  may  have  happened,  except  those  who 
may  have  caused  their  dissent  therefrom  to  be  entered  at  large  upon  the 
minutes  of  such  directors  at  the  time,  or  were  not  present  when  the  same 
happened,  shall  jointly  and  severally  be  liable  to  such  corporation  and  to 
the  creditors  thereof  to  the  full  amount  of  the  capital  of  such  corporation 
so  divided,  withdrawn,  paid  out,  or  reduced;"  and  because  section  thirty 
of  the  General  Corporation  Law  of  New  Jersey  provides:  "  No  corporation 
shall  make  dividends,  except  from  the  surplus  or  net  profits  arising  from  its 
business,  nor  divide,  withdraw,  or  in  any  way  pay  to  the  stockholders,  or 
any  of  them,  any  part  of  its  capital  stock,  or  reduce  its  capital  stock,  except 
according  to  this  act,  and  in  case  of  any  violation  of  the  provisions  of  this 
section  the  directors  under  whose  administration  the  same  may  happen 
shall  be  jointly  and  severally  liable  at  any  time  within  six  years  after  pay- 
ing such  dividends  to  the  corporation  and  to  its  creditors  in  the  event  of  its 
dissolution  or  insolvency  to  the  full  amount  of  the  dividend  made  or  capi- 
tal stock  so  divided,  withdrawn,  paid  out,  or  reduced,  with  interest  on  the 
same  from  the  time  such  liability  accrued;  provided  that  any  director  who 
may  have  been  absent  when  the  same  was  done,  or  who  may  have  dis- 

VOL.  I — 43 


674  AUDITING— GENERAL  PRINCIPLES 

sented  from  the  act  or  resolution  by  which  the  same  was  done,  may  exoner- 
ate himself  from  such  liability  by  causing  his  dissent  to  be  entered  at  large 
on  the  minutes  of  the  directors  at  the  time  the  same  was  done,  or  forthwith 
after  he  shall  have  notice  of  the  same,  and  by  causing  a  true  copy  of  said 
dissent  to  be  published  within  two  weeks  after  the  same  shall  have  been  so 
entered  in  a  newspaper  published  in  the  county  where  the  corporation  has 
its  principal  office;"  and  because  section  sixty  of  the  Stock  Corporation 
Law  of  this  State  provides:  "  Except  as  otherwise  provided  in  this  chapter 
the  officers,  directors  and  stockholders  of  a  foreign  stock  corporation 
transacting  business  in  this  state,  except  moneyed  and  railroad  corpora- 
tions, shall  be  liable  under  the  provisions  of  this  chapter,  in  the  same 
manner  and  to  the  same  extent  as  the  officers,  directors  and  stockholders 
of  a  domestic  corporation  for:  ist.  The  making  of  unauthorized  dividends 
.  .  .  Such  liabilities  may  be  enforced  in  the  courts  of  this  state  in  the 
same  manner  as  similar  liabilities  imposed  by  law  upon  the  officers,  direc- 
tors and  stockholders  of  domestic  corporations."  That  is,  by  virtue  of  the 
statutes,  this  State  allows  the  recovery  of  dividends  unauthorized  by  the 
State  of  New  Jersey  from  directors  of  a  New  Jersey  corporation  in  the 
same  manner  and  to  the  same  extent  as  the  directors  of  a  domestic  corpora- 
tion. That  is,  it  is  the  New  Jersey  statute  which  makes  the  dividend  un- 
authorized, but  the  recovery  is  to  be  had  according  to  the  New  York 
statute.  What,  then,  is  unauthorized?  "No  corporation  shall  make  divi- 
dends except  from  the  surplus  or  net  profits  arising  from  its  business." 
Net  profits  are  defined  in  the  Century  Dictionary  as  "what  remains  as 
the  clear  gain  of  any  business  after  deducting  the  capital  invested  in 
the  business,  the  expenses  incurred  in  its  management,  and  the  losses 
sustained  by  its  operation."  And  the  controlling  question  of  fact  is, 
were  these  dividends  paid  from  "net  profits"? 

The  twenty-one  branches,  located  in  many  places  and  in  different 
States,  which  were  actually  engaged  in  the  business  of  manufacturing  the 
malt  from  the  barley,  sent  in  to  the  general  office  in  New  York  daily, 
weekly  and  monthly  statements  in  great  detail  of  their  business.  From 
these  statements  branch  books  were  made  and  from  these  a  general  set 
of  books  was  prepared.  All  of  the  books  and  papers  from  the  general 
ofiice,  which  were  used  in  the  accounting  department,  were  produced  in 
court,  identified  and  marked  in  evidence.  The  defendant  objects  to  the 
summaries  made  up  from  these  books,  and  from  any  and  all  conclusions  of 
fact  to  be  drawn  from  said  books  and  said  summaries  upon  the  ground 
that  concededly  the  contracts  and  the  contract  books  were  not  produced 
and  were  not  considered.  It  was  in  evidence  that  malt  was  always  over- 
sold, that  contracts  for  future  deliveries,  running  over  many  months,  were 


THE  LIABILITIES  OF  DIRECTORS  675 

entered  into,  and  the  claim  is  that  such  contracts  were  required  to  be  taken 
into  consideration  when  it  came  to  be  determined  whether  any  particular 
dividend  was  warranted  or  not.  Such  claim,  in  my  opinion,  is  unfounded. 
The  law  is  that  ''No  corporation  shall  make  dividends  except  from  the 
surplus^  or  net  profits."  These  contracts  were  to  deliver  at  a  future  time  a 
product  not  yet  made  from  raw  material,  not  yet  purchased,  with  the  aid 
of  labor  not  yet  expended.  The  price  agreed  to  be  paid  at  that  future  time 
had  to  cover  all  the  possible  contingencies  of  the  market  in  the  meanwhile, 
and  might  show  a  profit,  and  ran  the  chance  of  showing  a  loss.  When  the 
sales  actually  took  place  they  were  entered  in  the  books.  But  to  calculate 
months  in  advance  on  the  result  of  the  future  transactions,  and  on  such 
calculations  to  declare  dividends,  was  to  base  such  dividends  on  paper 
profits — hoped  for  profits,  future  profits — and  not  upon  the  surplus  or  net 
profits  required  by  law.  It  does  not  seem  to  me  that  you  can  "divide," 
that  is,  make  a  dividend  of  a  hope  based  on  an  expectation  of  a  future 
delivery  at  a  favorable  price  of  what  is  not  yet  in  existence,  under  the 
statute.  So  the  objection  to  the  books  upon  that  ground  is  of  no  weight. 
From  the  books  certain  statements  were  made  up  for  the  aid  of  the  court 
upon  different  theories  and  in  different  ways.  One  set  of  statements  was 
testified  to  be  exactly  what  the  books  showed,  without  the  change  of  a 
figure.  These  exhibits  are  known  as  10  P,  10  Q.  As  to  these  statements  I 
do  not  understand  that  there  is  any  controversy  as  to  the  accuracy  of  the 
figures.  A  second  statement,  known  as  10  R,  10  S,  is  identical  with  the 
foregoing,  with  the  elimination  of  one  entry,  which,  as  a  matter  of  fact, 
was  eliminated  by  the  company  itself  some  months  after  its  entry.  There 
was  entered  on  the  books  on  the  31st  of  December,  1898,  an  item  of  $388,- 
063.36  of  the  anticipated  or  estimated  future  profits  on  contracts  for  future 
deliveries  running  over  many  months.  This  entry,  for  the  reasons  slated 
in  regard  to  the  contracts  for  future  deliveries,  was  unjustifiable.  The  com- 
pany subsequently  removed  this  entry.  The  actual  transactions,  that  is,  the 
deliveries  of  the  malt  called  for  by  the  contracts  and  the  receipts  in  pay- 
ment therefor  being  reported  from  time  to  time  as  they  occurred,  resulting 
in  double  credits,  the  cancellation  or  reversal  of  the  entry  was  absolutely 
required.  On  the  other  hand,  I  find  against  the  plaintiffs  in  regard  to  their 
contention  as  to  the  increase  account.  Barley  is  bought  by  the  bushel  of 
forty-eight  pounds.  Malt,  the  manufactured  article  made  from  barley 
by  steeping,  is  dealt  in  by  the  bushel  of  thirty-four  pounds.  The  process 
of  manufacture  produces  about  fifteen  per  cent  more  of  malt  by  the  bushel 
than  the  barley  measures  from  which  it  is  produced.  The  amount  of  this 
fifteen  per  cent  excess  is  reported  from  each  of  the  manufactories  month 
by  month  as  increase.    Of  course,  this  increase  has  a  value,  as  it  is  sold  as 


676  AUDITING— GENERAL  PRINCIPLES 

malt  at  malt  prices.  For  the  purpose  of  inventory  the  company  has 
ascribed  to  it  the  value  of  the  barley.  This,  plaintiffs  claim,  is  error, 
because  that  amount  has  already  once  been  charged  to  malt  account,  and 
they  say  this  increase  should  have  no  value  ascribed  to  it  until  sold  and 
delivered,  when  its  proceeds  go  into  the  books  as  cash.  But  it  certainly  is 
an  asset  of  the  company,  and  as  an  asset  at  inventory  periods,  or  when  it  is 
necessary  to  ascertain  the  actual  condition  of  the  company,  it  must  be 
valued  in  some  way.  As  it  has  always  been  the  custom  in  the  malting 
business  to  treat  it  as  treated  by  this  company,  I  am  unwilling  to  dis- 
regard that  custom.  The  accounts  upon  which  I  based  my  conclusions 
treated  it  as  the  company  did.  I  find  that  at  the  time  of  the  declaration 
and  payment  of  the  third  dividend,  July,  1898,  a  deficit  was  caused  there- 
by of  $142,774.59,  and  from  that  time  to  the  end  of  the  period  under 
consideration  none  of  the  dividends  were  paid  out  of  net  profits,  but  all 
were  paid  out  of  capital.  But  it  appears  that  defendant,  Curtiss,  was  not 
present  at  the  meeting  on  February  28,  1899,  when  the  dividend  paid 
April  15,  1899,  was  authorized.  Under  the  New  York  statute — under 
which  we  are  proceeding — a  director  who  was  not  present  when  the  divi- 
dend was  declared  is  not  liable.  The  approval  of  the  minutes  at  the  follow- 
ing June  meeting,  at  which  he  was  present,  was  only  the  authentication  of 
the  proof  of  what  had  happened  at  the  previous  meeting.  He  is,  there- 
fore, not  to  be  held  liable  for  that  dividend.  He  is  liable,  in  my  judgment, 
as  follows:  For  dividends  paid  July  15, 1898,  to  the  extent  of  $142,774.59; 
October  15,  1898,  $219,450;  January  15,  1899,  $219,450;  July  15,  1899, 
$252,700;  October  15,  1899,  $252,700 — $1,087,074.59,  with  interest  there- 
on from  the  several  dates  of  payment.  As  the  highest  court  of  New  Jersey, 
interpreting  the  law  of  the  State  under  which  this  company  was  incor- 
porated, held,  ''for  the  full  protection  of  the  company  the  liability  of  the 
directors  must  be  absolute"  (Appleton  v.  Am.  Malting  Co.)  I  find  against 
the  defendant  upon  his  claim  that  the  accrued  profits  of  the  company, 
made  under  a  changed  management,  can  be  credited  in  his  favor  against 
his  liability.  It  is  claimed  that  this  is  a  harsh  law.  If  it  were  such  com- 
plaint should  be  made  to  the  Legislature  and  not  to  the  court.  It  does  not 
seem  to  me  that  in  these  days  of  great  corporations  and  of  combinations 
into  one  of  many  corporations  it  is  asking  too  much  of  directors,  fiduciary 
officers  as  they  are,  that  they  should  obey  the  law  of  their  incorporation 
and  not  bring  their  companies  to  the  verge  of  bankruptcy  and  ruin  by  the 
payment  of  quarterly  dividends  on  preferred  stock  out  of  capital  instead 
of  net  earnings.  As  to  the  second  cause  of  action:  While  the  allegations 
are  profuse  as  to  a  "  willful,  fraudulent,  and  illegal  conspiracy, "  the  proof 
failed  to  establish  that  there  was  any  such  conspiracy  for  defendant's 


THE  LIABILITIES  OP  DIRECTORS  677 

personal  benefit.  The  cases  establishing  the  cause  of  action  pointed  at  in 
these  allegations  have  been  where  directors  have  diverted  to  themselves 
for  their  own  benefit  the  property  of  the  company.  The  damage  here 
flowed  out  of  the  making  of  the  dividends,  if  any  there  was.  It  was  alleged 
that  the  company  had  to  issue  bonds,  and  that  the  commissions,  discounts, 
and  interest  thereon  amount  to  $650,000,  which,  as  a  waste  of  its  funds, 
the  plaintiff  seeks  to  recover.  But  as  I  find  that  this  flowed  as  a  damage 
only  from  the  declaration  and  payment  of  the  dividends,  I  am  persuaded 
by  the  language  of  Mr.  Justice  Hatch  in  Hutchinson  v.  Stadler^  supra,  that 
it  does  not  under  the  facts  of  this  case  constitute  a  separate  cause  of  action. 
He  says :  "  In  point  of  fact  the  statute  of  the  State  of  New  Jersey  upon  this 
subject,  as  well  as  our  own,  does  little  more  than  lay  down  a  rule  of  damage 
to  be  enforced  against  directors  for  breach  of  duty.  At  common  law  a 
recovery  could  be  had  for  the  waste,  but  the  extent  of  the  recovery  would 
depend  upon  the  damage  sustained  by  the  corporation  and  be  the  subject 
of  proof.  The  statute  measures  the  loss  sustained,  which  is  usually  the 
correct  amount,  and  authorizes  a  recovery  therefor  of  the  individuals 
who  produced  that  result."  It  seems  to  me  that  any  other  theory  would 
result  in  turning  the  amount  recovered  for  illegal  dividends  into  a  penalty. 
The  Court  of  Errors  and  Appeals  of  New  Jersey  in  this  very  matter,  as 
well  as  our  Appellate  Division,  have  held:  "The  liability  imposed  by  the 
statute  is  not  penal  in  its  character.  Its  sole  purpose  is  not  to  punish,  but 
to  provide  for  the  making  of  compensation  by  wrongdoers  for  the  injury 
sustained  by  their  wrongful  act."  This  alleged  loss  must,  therefore,  be 
held  to  have  been  included  in  that  for  which  the  defendant  is  required  tc 
make  compensation  by  paying  into  the  company  an  amount  equal  to  the 
illegal  dividends. 


APPENDIX  A 

UNIFORM  ACCOUNTING 

A  Tentative  Proposal  Submitted  by  the  Federal  Re- 
serve Board,  Washington,  for  the  Consideration  of 
Banks,  Bankers,  and  Banking  Associations;  of  Manu- 
facturers, Auditors,  Accountants,  and  Associations  of 
Accountants 

(Reprinted  from  the  Federal  Reserve  Bulletin,  April  191 7) 

Introduction 

Through  the  courtesy  of  the  Federal  Trade  Commission  the  Federal 
Reserve  Board  has  been  enabled  to  take  advantage  of  a  large  amount  of 
information  and  data  which  the  Trade  Commission  acquired  in  connection 
with  the  study  of  the  statements  made  by  merchants,  manufacturers,  etc., 
as  showing  the  condition  of  their  business.  Because  this  matter  was  clearly 
of  importance  to  banks  and  bankers,  and  especially  to  the  Federal  Reserve 
Banks  which  might  be  asked  to  rediscount  commercial  paper  based  on 
borrowers'  statements,  the  Federal  Reserve  Board  has  taken  an  active 
interest  in  the  consideration  of  the  suggestions  which  have  developed  as  a 
result  of  the  Trade  Commission's  investigation,  and  now  submits  in  the 
form  of  a  tentative  statement  certain  proposals  in  regard  to  suggested 
standard  forms  of  statements  for  merchants  and  manufacturers 

The  problem  naturally  subdivides  itself  into  two  parts : 

(i)  The  improvement  in  standardization  of  the  forms  of  statements. 

(2)  The  adoption  of  methods  which  will  insure  greater  care  in  compil- 
ing the  statements  and  the  proper  verification  thereof. 

In  recent  years  bankers,  through  their  associations  and  otherwise,  have 
made  rapid  progress  in  the  direction  of  more  uniform  and  complete  forms 
of  statements.  Much  has  also  been  accomplished  in  the  improvement  of 
the  quality  of  the  statements  rendered  and  in  securing  statements  which 
do  not  depend  for  their  accuracy  on  the  borrower's  statement  alone  but 
are  verified  to  a  greater  or  less  extent  by  independent  scrutiny  and  audit. 
The  advantage  of  a  statement  certified  by  trustworthy  public  accountants 
over  an  unverified  statement  is  evident.    At  the  present  time,  however, 

679 


68o  APPENDIX 

there  is  no  uniformity  as  to  the  extent  of  verification  in  the  case  of  state- 
ments put  forward  as  having  been  verified. 

The  Federal  Trade  Commission  in  the  course  of  its  investigation  of 
business  conditions  has  been  strongly  impressed  with  the  lack  of  uniform- 
ity and  has  enlisted  the  aid  of  the  American  Institute  of  Accountants,  with 
a  view  to  remedying  the  condition.  It  has  found  that  verified  statements 
may  be  divided  broadly  into 

(a)  Those  in  which  the  certificate  is  based  on  an  examination  of  the 
books  without  personal  supervision  of  inventories  and  independent  ap- 
praisal of  all  assets  with  the  aid  of  technical  appraisers;  and 

(b)  Statements  verified  with  the  personal  supervision  of  inventories 
and  independent  appraisal  of  all  assets. 

The  value  of  the  two  classes  of  audits  and  their  relation  to  each  other 
depends  to  a  great  extent  upon  the  character  and  magnitude  of  the  business 
involved. 

In  some  cases  method  (b)  has  advantages  over  method  (a).  In  other 
cases,  notably  those  of  large  companies  in  which  personal  supervision  of 
inventories  is  arduous  and  perhaps  impracticable  and  the  value  of  an  in- 
dependent appraisal  of  assets  is  liable  to  be  considerably  exaggerated,  the 
reverse  may  be  true.  That  is  to  say,  a  verification  based  upon  the  books 
themselves  without  an  appraisal  may  be  and  often  is  the  safer  method  of 
procedure.  It  is  highly  desirable  gradually  to  educate  the  business  world 
to  the  great  importance  of  a  complete  form  of  audit  statement,  although 
any  plan  for  immediate  adoption  intended  to  produce  practical  results 
must  recognize  that  under  present  practice  probably  more  than  90  per  cent 
of  the  statements  certified  by  public  accountants  are  what  are  called  bal- 
ance-sheet audits,  such  as  are  described  in  paragraph  (a)  above  referred  to. 

As  a  first  step  toward  the  standardization  of  balance-sheet  audits  and 
to  insure  greater  care  in  compiling  and  verifying  statements  the  Federal 
Trade  Commission  requested  the  American  Institute  of  Accountants  to 
prepare  a  memorandum  on  balance-sheet  audits.  This  memorandum  was 
duly  prepared  and  approved  by  the  council  of  the  institute  representing 
accountants  in  all  sections  of  the  country. 

After  approval  by  the  Federal  Trade  Commission  the  memorandum 
was  placed  before  the  Federal  Reserve  Board  for  consideration.  The 
Federal  Reserve  Board,  after  conferences  with  representatives  of  the  Fed- 
eral Trade  Commission  and  the  American  Institute  of  Accountants,  and  a 
careful  consideration  of  the  memorandum  in  question,  has  accepted  the 
memorandum,  given  it  a  provisional  or  tentative  indorsement,  and  sub- 
mitted it  to  the  banks,  bankers,  and  banking  associations  throughout  the 
country  for  their  consideration  and  criticism. 


UNIFORM  ACCOUNTING  ,    68 1 

The  recommendations  in  the  memorandum  apply  primarily  to  what 
are  known  as  balance-sheet  audits.  This  is  an  initial  step  which 
may  easily  be  succeeded  by  future  developments  tending  still  further 
to  establish  uniformity  and  covering  more  fully  the  field  of  financial 
statements. 

General  Instructions  for  a  Balance-sheet  Audit  of  a 
Manufacturing  or  a  Merchandising  Concern 

The  scope  of  a  balance-sheet  audit  for  a  fiscal  year  or  other  operating 
period  of  an  industrial  or  mercantile  corporation  or  firm  comprises  a  veri- 
fication of  the  assets  and  liabilities,  a  general  examination  of  the  profit 
and  loss  account,  and,  incidental  thereto,  an  examination  of  the  essential 
features  of  the  accounting. 

Trial  balances  of  the  general  ledger,  both  at  the  beginning  and  end  of 
the  period  under  review,  should  be  prepared  in  comparative  form  and 
checked  with  the  ledger.  The  items  in  the  trial  balances  should  be  traced 
into  the  balance  sheets  before  the  assets  and  liabilities  are  verified,  to 
prove,  among  other  things,  that  no  '"contra"  asset  or  liability  has  been 
omitted  from  the  accounts,  that  the  assets  and  liabilities  have  been 
grouped  in  the  same  manner  at  the  beginning  and  at  the  end  of  the 
period,  and  also  that  the  balance  sheets  are  in  accordance  with  the 
books.  The  disposition  of  any  general  ledger  assets  and  liabilities  that 
may  have  been  scrapped,  sold,  written  off,  or  liquidated  during  the 
period  under  review  should  be  traced  and  noted  in  the  working  papers. 
Furthermore,  a  general  scrutiny  of  the  general  ledger  should  be  made  to 
see  that  the  accounts,  if  any,  that  have  been  opened  and  closed  during 
the  year  have  no  bearing  on  the  company's  financial  position  at  the  close 
of  the  fiscal  period. 

The  auditor  should  obtain  a  copy  each  of  the  balance  sheets  at  the 
beginning  and  the  end  of  the  period  to  be  audited,  and  should  make  a  com- 
parison between  them,  so  that  a  comprehensive  view  may  be  had  by  him 
of  the  changes  in  the  figures  during  the  period  under  review.  A  statement 
of  the  disposition  of  the  profits  should  then  be  prepared  from  this  compara- 
tive balance  sheet  as  a  further  aid  in  impressing  the  meaning  of  the  figures 
upon  the  mind  of  the  auditor. 

The  verification  of  assets  and  liabilities  for  convenience  will  be  con- 
sidered in  the  order  in  which  the  items  appear  in  the  form  of  balance  sheet 
attached  hereto.  This  form  of  statement  has  been  determined  by  the  de- 
sire to  meet  as  nearly  as  possible  the  requirements  and  practice  of  Federal 
Reserve  Banks. 


682  APPENDIX 

Specific  Instructions  and  Suggestions  Relating  to  the 
Separate  Headings 

CASH 

The  cash  on  hand  preferably  should  be  counted  after  banking  hours  on 
the  last  day  of  the  fiscal  period  to  be  covered  by  the  audit,  and  the  amount 
thereof,  together  with  the  cash  stated  to  be  in  the  bank,  reconciled  with 
that  shown  by  the  cashbook.  The  cash,  bills  receivable,  and  investments 
must  be  examined  on  the  same  day,  so  as  to  make  it  impossible  for  a 
treasurer  to  make  up  a  shortage  in  one  asset  by  withdrawing  negotiable 
funds  temporarily  from  another. 

In  counting  the  cash  on  hand  the  auditor  must  see  that  all  customers' 
checks  produced  to  him  as  part  of  the  cash  balance  have  been  duly  entered 
in  the  cashbook  prior  to  the  close  of  the  period  and  should  note  the  dates 
and  descriptions  of  such  checks,  and  also  the  dates  and  descriptions  of  all 
advances  made  from  cash  and  not  recorded  on  the  books.  Advances  to 
employees  should  be  strictly  investigated,  and  if  any  are  secured  by  per- 
sonal checks  the  auditor  should  see  that  the  checks  are  certified  by  the 
bank  on  which  they  are  drawn  before  the  close  of  the  audit. 

Certificates  must  be  obtained,  as  of  the  evening  of  the  closing  date, 
from  the  banks  in  which  cash  is  deposited,  by  or  mailed  directly  to,  the 
auditor  himself.  The  balances  as  shown  by  the  certificates  must  be  recon- 
ciled with  those  shown  on  either  the  cashbook,  the  checkbook  stubs,  or 
bank  registers,  taking  into  consideration  outstanding  checks. 

In  verifying  the  outstanding  checks  there  is  only  one  safe  and  satis- 
factory method  of  proving  their  accuracy,  and  that  is  to  compare  the  credit 
side  of  the  cashbook  from  the  last  day  of  the  fiscal  period  backward,  item 
by  item,  with  the  checks  returned  from  the  bank  for  such  period  as  may  be 
necessary  to  account  for  all  current  outstandings.  Any  old  checks  not  yet 
cashed  by  banks  should  be  made  the  subject  of  special  inquiry.  When 
this  work  is  completed,  a  list  of  the  outstanding  checks  so  ascertained 
should  be  prepared,  showing  the  dates  of  the  checks  and  compared  with 
the  actual  checks  returned  from  the  bank  at  a  later  date,  and  any  not  so 
returned  should  be  specially  investigated.  Special  care  is  necessary  to  see 
that  no  checks  for  cash  purposes  are  drawn  at  the  close  of  the  period  and 
entered  in  the  next  period. 

Where  the  currency  and  bank  transactions  are  kept  together  in  the 
cashbook  and  the  auditor  does  not  count  the  cash  until  a  date  subsequent 
to  the  close  of  the  fiscal  year,  he  must,  in  addition  to  verifying  the  bank 
balances  as  of  the  close  of  the  year,  verify  them  as  of  the  date  of  the  count 


UNIFORM  ACCOUNTING  683 

of  cash.  This  is  absolutely  essential  when  it  is  considered  that, 
although  the  cash  on  hand,  which  forms  only  part  of  the  balance,  at 
the  date  of  the  count  is  correct,  it  does  not  follow  that  the  total  cash  is 
correct. 

When  receipts  are  shown  in  the  cash  books  as  being  deposited  in  the 
bank  on  the  last  day  of  the  fiscal  period,  but  are  included  in  the  reconcilia- 
tion statement  on  account  of  their  not  being  paid  into  the  bank  until  the 
next  day,  the  auditor  must  obtain  letters  from  the  banks  acknowledging 
such  deposits. 

The  deposits  shown  in  the  pass  books  should  be  checked  in  detail  for 
the  last  two  or  three  days  of  the  fiscal  period  from  the  books  to  prove  that 
they  were  composed  of  bona  fide  checks,  and  that  no  check  drawn  by  the 
company  was  deposited  in  a  bank  without  being  credited  to  the  bank  on 
which  it  was  drawn  prior  to  the  close  of  the  fiscal  period. 

So  that  the  auditor  may  satisfy  himself  that  deposits  are  promptly 
made  in  bank  each  day,  and  that  the  same  checks  are  paid  into  bank  as  are 
received,  it  is  advisable  to  call  for  a  number  of  deposit  slips  and  compare 
them  with  the  receipts  as  shown  by  the  cashbook  for  the  days  in  which  the 
deposits  are  made.  To  make  such  verification  absolute  the  deposit  slips 
should  be  obtained  from  the  banks. 

When  the  practice  of  a  company  is  to  pay  all  of  its  cash  receipts  into 
bank,  they  should  be  compared  and  reconciled  with  the  total  deposits,  as 
shown  by  the  bank  books,  and  similarly  the  disbursements  should  be 
reconciled  with  the  total  checks  drawn. 

Outstanding  checks  not  examined  at  a  previous  audit  on  account  of  not 
having  been  returned  by  the  banks  must  be  called  for  and  traced  into  the 
cashbook  at  the  beginning  of  the  current  audit. 

NOTES  RECEIVABLE 

A  list  of  notes  receivable  outstanding  at  the  end  of  the  fiscal  period 
should  be  prepared,  showing  the  dates  the  notes  are  made,  the  customers' 
names,  the  date  due,  the  amounts  of  the  notes  and  the  interest,  if  any, 
contained  in  the  notes.  If  discounted,  the  name  of  the  discounting  bank 
should  be  noted  and  verification  obtained  from  the  bank. 

The  outstanding  notes  must  be  carefully  examined  with  the  notes- 
receivable  book,  and  with  the  list  prepared  by  or  produced  to  the  auditor, 
the  due  dates  and  the  dates  of  making  the  notes  being  carefully  checked, 
and  when  notes  have  been  renewed  the  original  dates  should  be  recorded. 
When  notes  have  been  paid  since  the  close  of  the  fiscal  year,  the  cash  should 
be  traced  into  the  books  of  the  company,  and,  when  they  are  in  the  hands  of 


684  APPENDIX 

attorneys  or  bankers  for  collection,  certificates  should  be  obtained  from 
the  depositaries. 

When  notes  receivable  are  discounted  by  banks  the  company  has  a 
liability  therefor  which  should  appear  on  the  balance  sheet.  Lists  of  dis- 
counted notes  not  matured  at  the  date  of  the  audit  should  be  obtained 
from  the  banks  as  verification  and  their  totals  entered  under  20a  if  the  cash 
therefor  is  shown  as  an  asset. 

The  value  of  collateral,  if  any,  held  for  notes  should  be  ascertained,  as  it 
frequently  happens  that  the  notes  are  worth  no  more  than  the  collateral. 

Notes  due  by  officials  and  employees  must  always  be  stated  sepaiately 
from  customers'  notes,  as  must  also  notes  received  for  other  than  trade 
transactions. 

Notes  due  from  affiliated  concerns  must  not  be  included  as  customers' 
notes,  even  though  received  as  a  result  of  trading  transactions.  Affiliated 
companies'  notes  should  be  shown  as  a  separate  item  of  current  assets  or  as 
other  assets  as  the  circumstances  warrant.  They  may  be  fail ly  included  in 
current  assets  if  the  debtor  company  has  ample  margin  of  quick  assents 
over  its  liabilities,  including  such  notes. 

The  term  "  quick  assets"  is  used  here  in  the  sense  in  which  it  is  used  by 
Federal  Reserve  practice.  "  Current  assets"  is  used  to  comprise  these  as- 
sets and  other  assets  which,  though  current,  are  excluded  in  determining 
the  eligibility  of  the  paper  for  Federal  Reserve  purposes. 

Optional. — The  best  verification  of  notes  receivable  is  an  acknowledg- 
ment by  the  party  named  in  each  note  as  the  payor  on  the  due  date  that 
the  note  is  a  bona  fide  obligation.  Therefore  if  time  permits,  and  the  client 
does  not  object,  it  is  advisable  to  obtain  such  written  confirmation  for 
each  note.  The  auditor  should  personally  mail  the  letters,  inclosing 
stamped  envelope  for  reply  addressed  direct  to  himself. 

ACCOUNTS  RECEIVABLE 

The  bookkeepers  of  the  accounts-receivable  ledgers  should  be  asked  to 
draw  off  lists  of  the  open  balances  at  the  end  of  the  fiscal  period,  and  dis- 
tributions of  the  total  columns  should  be  shown  on  the  lists  according  to 
the  age  of  the  accounts,  e.g.,  not  yet  due,  less  than  30  days  past  due,  more 
than  30  days  past  due.  The  accounts  paid  since  the  close  of  the  fiscal 
period  should  be  noted  in  the  lists  before  taking  up  the  matter  of  past-due 
accounts  with  the  credit  department,  as  payment  is  the  best  proof  that  an 
account  was  good  at  the  date  of  the  audit. 

The  totals  of  the  lists  of  outstanding  accounts  should  agree  with  the 
controlling  account  in  the  general  ledger  if  separate  ledgers  are  kept. 


UNIFORM  ACCOUNTING  685 

When  credit  balances  appear  on  customers'  accounts  they  should  be  shown 
on  the  balance  sheet  as  a  separate  item  and  not  deducted  from  the  total 
of  debit  balances;  and  debit  balances  on  the  accounts-payable  ledgers 
should  be  treated  in  the  same  manner. 

The  lists  must  be  footed  and  compared  in  detail  with  the  customers' 
accounts  in  the  ledgers. 

The  composition  of  outstanding  balances  should  always  be  examined, 
as  it  frequently  happens  that  while  a  customer  may  be  making  regular 
payments  on  his  account,  old  items  are  being  carried  forward  which  have 
been  in  dispute  for  a  considerable  period  of  time.  Such  items  and  accounts 
which  are  past  due  should  be  taken  up  with  the  credit  department  or  some 
responsible  officer,  and  the  correspondence  with  the  customers  examined, 
so  that  the  auditor  may  form  an  opinion  of  the  worth  of  the  accounts  and 
satisfy  himself  that  the  reserve  for  bad  and  doubtful  accounts  set  up  by  the 
company  is  sufficient. 

Trade  discounts  (and  also  so-called  cash  discounts,  if  exceeding  i  per 
cent)  and  freights  allowed  by  the  company  should  be  inquired  into,  and  if 
they  have  been  included  in  the  accounts  receivable  a  reserve  therefor 
should  be  set  up  in  the  balance  sheet.  Also  inquiries  should  be  made  re- 
garding customers'  claims  for  reductions  in  prices  and  for  rebates  and 
allowances  on  account  of  defective  materials,  so  that  it  may  be  seen  that  a 
sufficient  reserve  has  been  established  therefor. 

Inquiry  must  be  made  as  to  whether  any  of  the  accounts  receivable 
have  been  hypothecated  or  assigned,  and  the  sum  total  of  accounts  so 
listed  entered  under  20b. 

The  auditor  should  satisfy  himself  that  the  bad  debts  written  off  have 
been  duly  authorized  by  responsible  officials. 

Accounts  due  from  directors,  officers,  and  employees  must  be  stated  in 
the  balance  sheet  separately  and  not  included  as  trade  accounts.  This 
applies  also  to  deposits  as  security,  guaranties,  and  other  extraordinary 
items  not  connected  with  sales. 

Accounts  due  from  affiliated  concerns  must  not  be  included  as  cus- 
tomers' accounts,  even  though  arising  as  a  result  of  trading  transactions. 
Affiliated  companies'  accounts  should  be  shown  as  a  separate  item  of 
" current  assets"  or  as  "other  assets,"  as  the  circumstances  warrant.  They 
may  be  fairly  included  as  "  current  assets"  if  the  debtor  company  has  ample 
margin  of  quick  assets  over  its  liabilities,  including  such  accounts. 

Optional. — The  best  verification  of  an  open  balance  is  a  confirmation  by 
the  customer;  therefore,  if  time  permits  and  the  client  does  not  object,  it  is 
advisable  to  circularize  the  customers.  The  auditor  should  personally  see- 
the circulars  mailed  after  comparing  them  with  the  lists  of  outstanding 


686  APPENDIX 

accounts.    The  envelopes  for  replies  sent  with  the  circulars  should  be 
addressed  direct  to  the  auditor. 

In  large  concerns  the  system  of  accounting  is  generally  so  arranged  that 
it  would  be  almost  impossible  for  accounts  to  be  paid  and  not  correctly 
credited  on  the  accounts-receivable  ledgers,  but  in  small  concerns,  with 
imperfect  systems,  such  occurrences  are  quite  possible,  so  much  so,  in  fact, 
that  it  is  generally  admitted  that  the  risk  of  errors  and  omissions  decreases 
in  direct  proportion  to  an  increase  in  bookkeeping. 

SECURITIES 

Under  this  caption  must  be  listed  securities  in  which  surplus  funds  of 
the  company  or  firm  have  been  temporarily  invested  and  which  are  con- 
sidered available  as  *  *  quick  assets, '  'i.e.,  can  be  turned  into  money  in  time  of 
need.  Where  stocks  or  bonds  represent  control  or  a  material  interest  in  other 
enterprises,  the  ownership  of  which  carries  more  or  less  value  to  the  holder 
outside  of  the  return  thereon,  they  should  be  considered  as  fixed  assets. 

A  list  of  investments  should  be  prepared  showing 

The  dates  of  purchases. 

Descriptions  of  the  investments. 

Par  value  of  the  investments. 

The  denomination  of  the  shares. 

The  number  of  shares  or  bonds  owned. 

The  total  capital  stock  of  the  various  companies. 

The  amounts  paid  for  the  investments. 

The  interest  and  dividends  received. 

The  market  values  of  the  investments.    . 

The  surplus  or  deficit  shown  by  the  balance  sheets  of  the  companies 

where  no  market  quotations  are  available. 
If  hypothecated,  with  whom  and  for  what  purpose. 

This  list  must  be  compared  with  the  ledger  accounts  concerned  and 
the  total  of  amounts  paid  according  to  the  list  must  agree  with  the  balance 
of  the  investment  account  or  accounts. 

The  securities  must  be  examined  by  the  auditor  in  person  or  he  must 
secure  confirmation  of  their  existence  from  those  who  hold  them  as  col- 
lateral. Those  in  possession  of  the  company  must  be  counted  and  ex- 
amined as  soon  as  possible  after  the  audit  starts,  and  all  of  them  must  be 
submitted  to  him  at  one  time.  It  is  much  more  satisfactory  to  see  the 
actual  securities  than  to  verify  cash  receipts  and  other  evidences  therefor 
af  tei  the  audit  has  progressed  some  time. 


UNIFORM  ACCOUNTING  687 

r 

Certificates  out  for  transfer  must  be  verified  by  correspondence. 

Where  the  market  values  of  securities  are  less  than  the  book  values, 
save  where  the  variation  is  so  small  as  to  be  trifling,  a  reserve  for  loss  in 
value  on  the  balance-sheet  date  must  be  set  up. 

Care  must  be  taken  to  see  that  the  certificates  are  made  out  in  favor  of 
the  company,  or  that  they  are  indorsed  or  accompanied  by  powers  of 
attorney  when  they  are  in  the  names  of  individuals. 

Coupons  on  bonds  must  be  examined  to  see  that  they  are  intact  sub- 
sequent to  the  latest  interest  payment  date. 

The  investment  schedule  must  show  that  the  total  interest  and  divi- 
dends receivable  by  the  company  have  been  duly  accounted  for;  the  in- 
come from  the  investments  shown  in  the  profit  and  loss  account  must  be 
in  accord  with  this  schedule. 

When  market  quotations  can  not  be  obtained  for  investments,  the 
balance  sheets  of  the  companies  in  which  investments  are  held  must  be 
examined  so  that  the  auditor  may  form  an  idea  of  their  value. 

In  verifying  purchases  of  stock  exchange  securities  the  brokers'  ad- 
vices must  in  all  cases  be  examined  in  connection  with  the  verification  of 
the  purchase  price. 

Investments  in  deeds  and  mortgages  must  be  supported  by  both  the 
mortgages  and  insurance  policies,  and,  furthermore,  it  must  be  shown  that 
all  assessed  taxes  on  the  property  have  been  duly  paid,  that  the  mortgages 
have  been  properly  recorded,  and  that  the  insurance  policies  are  correctly 
made  out  to  the  company. 

If  any  of  the  securities  have  been  hypothecated  the  fact  and  amount 
(book  value)  must  be  stated  under  2od  of  the  balance  sheet. 

INVENTORIES 

Under  this  caption  must  be  included  only  stocks  of  goods  owned  and 
under  control  of  the  owner.  Stocks  are  often  hypothecated  and  if  this  is 
the  case  the  fact  should  be  stated  on  the  balance  sheet. 

Inasmuch  as  the  accuracy  of  the  profit  and  loss  account  is  absolutely 
dependent  upon  the  accuracy  of  the  inventories  of  merchandise  at  the 
beginning  and  end  of  the  period  under  review,  this  part  of  the  verification 
should  receive  special  attention.  When  a  balance-sheet  audit  is  being 
made  for  the  first  time,  the  inventory  at  the  beginning  of  the  period  should 
receive  as  much  attention  as  that  at  the  end,  and  the  auditor  should  take 
every  precaution  to  satisfy  himself  that  both  inventories  were  taken  on  the 
same  basis. 

An  acceptable  program  of  audit  for  inventories  is  as  follows: 


688  APPENDIX 

(i)  Secure  the  original  stock  sheets  if  they  are  in  existence  and  care- 
fully test  the  typewritten  copies  with  them  and  with  tickets,  cards,  or 
other  memoranda  that  show  the  original  count. 

(2)  See  that  the  sheets  are  certified  to  or  initialed  by  the  persons  who 
took  the  stock,  made  the  calculations  and  footings,  and  fixed  the  prices, 
and  satisfy  yourself  that  they  are  dependable  and  responsible  persons. 
Obtain  a  clear  and  detailed  statement  in  writing  as  to  the  method  followed 
in  taking  stock  and  pricing  it;  also  a  certificate  from  a  responsible  head  as 
to  the  accuracy  of  the  inventory  as  a  whole. 

(3)  A  thorough  test  of  the  accuracy  of  the  footings  and  extensions 
should  be  made,  especially  of  all  large  items. 

(4)  The  inventories  should  be  compared  with  the  stores  ledger,  work 
in  progress  ledgers  and  finished  product  records  and  stock  records  as  to 
quantities,  prices,  and  values,  and  any  material  discrepancy  should  be 
thoroughly  traced. 

(5)  Where  stock  records  are  kept  and  no  physical  inventory  is  taken 
at  the  time  of  the  audit,  ascertain  when  the  last  physical  inventory  was 
taken  and  compare  it  with  the  book  records.  If  no  recent  comparison  is 
possible,  select  a  few  book  items  of  importance  and  personally  compare 
with  the  actual  stock  on  hand. 

(6)  Where  no  stock  records  are  kept,  a  physical  inventory  should  be 
taken  preferably  under  the  general  direction  of  the  auditor.  After  the 
inventory  is  completed,  he  should  apply  the  same  tests  to  verify  its  accu- 
racy as  if  the  inventory  had  been  taken  before  his  arrival  upon  the  scene. 

(7)  When  the  cost  system  of  a  company  does  not  form  a  part  of  the 
financial  accounting  scheme  there  is  always  a  chance  that  orders  might  be 
completed  and  billed,  but  not  taken  out  of  the  work  in  progress  records. 
Especially  is  this  the  case  when  reliance  is  placed  on  such  records  to  the 
extent  that  a  physical  inventory  is  not  taken  at  the  end  of  the  period  to 
verify  the  information  shown  therein.  In  these  cases  the  sales  for  the 
month  preceding  the  close  of  the  fiscal  period  should  be  carefully  compared 
with  the  orders  in  progress  as  shown  by  the  inventory,  to  see  that  nothing 
that  has  been  shipped  is  included  in  the  inventory  in  error.  Cost  systems 
which  are  not  coordinated  with  the  financial  accounts  are  unreliable  and 
frequently  misleading.  Special  attention  should  be  called  to  every  case  in 
which  the  cost  system  is  not  adequately  checked  by  the  results  of  the 
financial  accounting. 

(8)  Ascertain  that  purchase  invoices  for  all  stock  included  in  the  in- 
ventory have  been  entered  on  the  books.  Look  for  postdated  invoices  and 
give  special  attention  to  goods  in  transit. 

(o)  See  that  nothing  is  included  in  the  inventory  which  is  not  owned 


UNIFORM  ACCOUNTING  689 

but  is  on  consignment  from  others.  If  goods  consigned  to  others  are 
included,  see  that  cost  prices  are  placed  thereon,  less  a  proper  allowance  for 
loss,  damage,  or  expenses  of  possible  subsequent  return.  This  does  not 
include  goods  at  branches,  as  the  valuing  of  such  stocks  will  be  governed 
by  the  same  principles  as  apply  at  the  head  office. 

(10)  Ascertain  that  nothing  is  included  which  has  been  sold  and  billed, 
and  is  simply  awaiting  shipment. 

(11)  If  duties,  freight,  insurance,  and  other  direct  charges  have  been 
added,  test  them  to  ascertain  that  no  error  has  been  made.  Duties  and 
freight  are  legitimate  additions  to  the  cost  price  of  goods,  but  no  other 
items  should  be  added  except  under  unusual  circumstances. 

(12)  As  a  check  against  obsolete  or  damaged  stock  being  carried  in  the 
inventory  at  an  excessive  valuation,  the  detailed  records  for  stores,  sup- 
plies, work  in  progress,  finished  products,  and  purchased  stock  in  trade, 
should  be  examined  and  a  list  prepared  of  inactive  stock  accounts,  which 
should  be  discussed  with  the  company's  officials  and  satisfactory  explana- 
tions obtained. 

(13)  The  auditor  should  satisfy  himself  that  inventories  are  stated  at 
cost  or  market  prices,  whichever  are  the  lower  at  the  date  of  the  balance 
sheet.  No  inventory  must  be  passed  which  has  been  marked  up  to  market 
prices  and  a  profit  assumed  that  is  not  and  may  never  be  realized.  If  the 
market  is  higher  than  cost,  it  is  permissible  to  state  that  fact  in  a  footnote 
on  the  balance  sheet. 

(14)  It  may  be  found  that  inventories  are  valued  at  the  average  prices 
of  raw  materials  and  supplies  on  hand  at  the  end  of  the  period.  In  such 
cases  the  averages  should  be  compared  with  the  latest  invoices  in  order  to 
verify  the  fact  that  they  are  not  in  excess  of  the  latest  prices,  and  also  with 
the  trade  papers,  when  market  prices  are  used,  to  see  that  they  are  not  in 
excess  of  market  values. 

(15)  Make  an  independent  inspection  of  the  inventory  sheets  to  deter- 
mine whether  or  not  the  quantities  are  reasonable,  and  whether  they  ac- 
cord in  particular  instances  with  the  average  consumption  and  average 
purchases  over  a  fixed  period.  Abnormally  large  quantities  of  stock  on 
hand  may  be  the  legitimate  result  of  shrewd  foresight  in  buying  in  a  low 
market,  but  may,  on  the  other  hand,  arise  from  serious  errors  in  stock 
taking. 

(16)  Always  attempt  to  check  the  totals  by  the  ''gross  profit  test "  and 
compare  the  percentage  of  gross  profit  shown  with  that  of  previous  years. 
In  a  business  where  the  average  gross  profit  remains  fairly  constant  this 
test  is  a  dependable  one,  because,  if  the  rate  of  gross  profit  is  apparently 
not  maintained  and  the  discrepancy  can  not  be  satisfactorily  accounted  for 

VOL.  I — 44 


690  APPENDIX 

by  a  rise  or  fall  in  the  cost  of  production  or  of  the  selling  price,  the  differ- 
ence will  usually  be  due  to  errors  in  stock  taking. 

(17)  In  verifying  the  prices  at  which  the  work  in  progress  is  included 
in  the  inventory,  a  general  examination  and  test  of  the  cost  system  in 
force  is  the  best  means  of  doing  this  work  satisfactorily.  In  a  good  cost 
system  little  difficulty  will  be  found  with  the  distribution  of  the  raw 
materials,  stores,  and  pay  roll,  but  the  distribution  of  factory  overhead 
cost  is  one  that  should  receive  careful  consideration,  the  main  points  to  be 
kept  in  view  being: 

(a)  That  no  selling  expenses,  interest  charges,  or  administrative  ex- 
penses are  included  in  the  factory  overhead  cost. 

(6)  That  the  factory  overhead  cost  is  distributed  over  the  various 
departments,  shops,  and  commodities  on  a  fair  and  equitable  basis. 

(18)  No  profit  should  be  included  in  the  price  of  finished  products  or 
stock  in  trade.  The  price  list  should  be  examined  to  see  that  the  cost  prices 
of  stock  are  below  the  selling  prices  after  allowing  for  trade  discounts^  and, 
if  they  are  not,  a  reserve  should  be  set  up  on  the  balance  sheet  for  this  loss. 
If  the  company  takes  immediatesteps  to  increase  the  selling  price,  however, 
the  amount  of  this  reserve  may  be  limited  to  the  loss  on  goods  which  may 
have  been  sold  since  the  close  of  the  period  to  the  date  of  the  discovery. 

(19)  In  the  case  of  companies  manufacturing  large  contracts  it  is  fre- 
quently found  necessary  to  make  partial  shipments  thereof.  The  question 
then  arises  as  to  whether  it  is  permissible  to  include  the  profits  on  these 
partial  shipments  in  the  profit  and  loss  account.  As  a  matter  of  fact,  it  is 
evident  that  the  actual  cost  can  not  be  known  until  the  order  is  completed. 
It  may  be  estimated  that  a  profit  will  ultimately  be  made,  yet  unforeseen 
conditions,  such  as  strikes,  delays  in  receiving  material,  etc.,  may  arise  to 
increase  the  estimated  cost.  It  is  better  not  to  include  the  profits  on  par- 
tial shipments,  but  information  of  this  character  which  may  have  its  in- 
fluence in  the  decision  of  the  banker  upon  a  proposed  loan  may  properly 
be  laid  before  him.  Of  course,  an  exception  should  be  made  in  cases  where 
the  profit  on  the  partial  shipments  largely  exceeds  the  selling  price  of  the 
balance  of  the  order. 

(20)  The  selling  prices  for  contract  work  in  progress  should  be  ascer- 
tained from  the  contracts,  and  where  it  is  apparent  that  there  will  be  a  loss 
on  the  completed  contract  a  due  proportion  of  the  estimated  loss  should  be 
charged  to  the  period  under  audit  by  setting  up  a  reserve  for  losses  on 
contracts  in  progress. 

(21)  If  a  company  has  discontinued  the  manufacture  of  any  of  its 
products  during  the  year,  the  inventory  of  such  products  should  be  care- 
fully scrutinized  and,  if  unsalable,  the  amount  should  be  written  off. 


I 


UNIFORM  ACCOUNTING  691 

(22)  The  inventory  should  be  scrutinized  to  see  that  no  machinery  or 
other  material  that  has  been  charged  to  plant  or  property  account  is  in- 
cluded therein. 

(23)  Partial  deliveries  received  on  account  of  purchase  contracts  for 
material,  etc.,  should  be  verified  by  certificates  from  the  contractors,  both 
as  to  quantities  and  prices. 

(24)  Advance  payments  on  account  of  purchase  contracts  for  future 
deliveries  should  never  appear  in  an  inventory,  but  be  shown  on  the  bal- 
ance sheet  under  a  separate  heading. 

(25)  Trade  discounts  should  be  deducted  from  inventory  prices,  but  it 
is  not  customary  to  deduct  cash  discounts.  However,  this  may  be  done 
when  it  is  the  trade  practice  so  to  do. 

(26)  While  the  inventory  is  being  verified,  the  auditor  should  ascertain 
the  aggregate  sales  for  the  last  year.  If  the  turnover  has  not  been  rapid, 
it  may  be  due  to  a  poor  stock  of  goods.  Some  business  men  dislike  to  sell 
below  cost  and  would  rather  accumulate  a  big  stock  of  old  goods  than 
disi)ose  of  the  old  and  unseasonable  stock  at  a  sacrifice.  The  usual  out- 
come is  that  the  stock  becomes  unwieldy  and  funds  are  lacking  to  purchase 
new  goods.  The  inventory  and  the  gross  sales  may,  therefore,  have  a  direct 
connection. 

(27)  It  may  be  well  to  reiterate  that  interest,  selling  expenses,  and 
administrative  expenses  form  no  part  of  the  cost  of  production,  and  there- 
fore should  not  be  included  in  the  inventory  in  any  shape. 

COST  OF  FIXED  PROPERTY 

In  preparing  the  leading  schedules  for  the  accounts  grouped  under  this 
heading,  such  as  real  estate,  buildings,  plant,  machinery,  etc.,  the  balances 
at  the  beginning  of  the  period,  the  additions  to  or  deductions  from  the 
accounts  during  the  year,  and  the  balances  at  the  end  of  the  period  must 
be  shown. 

The  total  of  the  balances  at  the  beginning  of  the  period  must  agree 
with  the  cost  of  property  figures  given  in  the  balance  sheet  at  that  date, 
and  the  balances  at  the  end  of  the  period  with  the  amount  shown  in  the 
balance  sheet  that  is  being  audited.  The  charges  entering  into  the  addi- 
tions must  be  verified  in  detail,  and  in  this  connection  the  following  notes 
are  of  value: 

(i)  Authorizations  for  the  expenditure  made  during  the  year  should  be 
examined,  and  where  the  costs  of  the  additions  have  overrun  the  sums 
authorized,  inquiries  should  be  made  in  regard  thereto.  The  authoriza- 
tions should  show  the  accounts  to  which  the  expenditures  are  chargeable. 


692  APPENDIX 

the  amounts  thereof,  the  approvals  of  the  comptroller  and  manager,  and 
descriptions  of  the  jobs.  When  the  authorizations  are  not  specific  as  to  the 
work  done,  the  actual  additions  should,  if  possible,  be  inspected. 

(2)  The  auditor  should  satisfy  himself  before  approving  additions  that 
they  were  made  with  the  object  of  increasing  the  earning  capacity  of  the 
plant,  and  that  they  are  not  of  the  nature  of  either  renewals  or  improve- 
ments, and  in  this  connection  changes  in  the  production  and  capacity  of 
the  plant  should  receive  consideration. 

(3)  To  verify  the  pay  roll  and  store  and  supply  charges  to  jobs,  one  or 
two  pay  roll  distribution  reports  should  be  examined  in  detail,  and  also  one 
or  two  storehouse  reports.  In  cases  where  large  purchases  have  been 
made  from  outside  parties  for  capital  construction  work,  the  vouchers 
therefor  should  be  examined  and  the  usual  precautions  taken  to  see  that 
they  are  properly  approved  for  the  receipt  of  materials,  prices,  etc. 

(4)  For  purchases  of  real  estate  the  title  deeds  should  be  examined, 
together  with  the  vouchers,  and  it  should  be  seen  that  the  deeds  have  been 
properly  recorded. 

(5)  While  it  may  be  considered  permissible  to  make  a  charge  for  factory 
overhead  cost  to  additions  to  property  such  as,  e.  g.,  time  of  superintendent 
and  his  clerical  force  employed  on  construction  work,  etc.,  it  can  not  be 
deemed  conservative  business  practice,  inasmuch  as  the  probabilities  are 
that  the  overhead  charges  of  a  plant  will  not  be  decreased  to  any  extent 
even  though  additions  are  not  under  way,  and,  therefore,  the  absorption 
of  part  of  these  charges  when  additions  are  in  progress,  has  the  effect  of 
reducing  the  operating  costs,  as  compared  with  months  in  which  no  con- 
struction work  is  under  way. 

(6)  Construction  work  in  progress  at  the  end  of  the  fiscal  period  should 
be  shown  in  the  balance  sheet  under  the  heading  of  fixed  assets  and  not  as 
part  of  the  inventories.  This  is  important  to  bear  in  mind  because  con- 
struction work  is  not  an  asset  that  can  be  quickly  turned  into  money, 
while  everything  in  the  inventory  is  supposed  to  be  realizable  in  cash 
within  a  reasonably  short  time. 

(7)  The  auditor  should  inquire  as  to  whether  any  installments  are 
due  on  account  of  construction  work  in  progress  which  is  being  carried  on 
by  outside  parties;  and  if  so,  the  liabilities  for  these  installments  should  be 
included  in  the  balance  sheet,  as  they  may  have  a  direct  bearing  on  the 
amount  of  available  cash  on  hand. 

(8)  When  a  company  uses  leasehold  properties  the  leases  should  be 
examined  and  notes  made  of  the  periods  covered,  so  that  it  may  be  seen 
that  improvements,  etc.,  on  such  properties  are  written  off  over  the  periods 
covered  by  the  leases. 


UNIFORM  ACCOUNTING  693 

(9)  The  auditor  should  satisfy  himself  that  the  reserves  for  depreciation 
of  buildings,  machinery,  equipment,  etc.,  are  adequate  to  reflect  the  deteri- 
oration in  the  value  of  the  fixed  properties.  If  in  his  opinion  the  reserves 
shown  on  the  balance  sheet  are  insufficient,  he  should  call  attention  to  the 
matter  in  his  certificate. 

(10)  Care  should  be  taken  to  insure  that  property  destroyed  by  fire  or 
otherwise  prematurely  put  out  of  service  is  correctly  treated  in  the  books. 
Any  portion  of  the  original  charge  for  such  property  which  is  not  recover- 
able through  insurance,  as  salvage  or  otherwise,  and  has  not  been  provided 
for  by  the  depreciation  scheme  should  be  written  off. 

It  is  to  be  observed  that  the  foregoing  notes  are  to  be  applied  only  to 
cost  of  properties  incurred  during  the  period  under  audit.  In  addition, 
information  may  usefully  be  obtained  on  broader  lines  in  regard  to  the 
composition  of  the  real  estate,  building,  and  machinery  accounts,  and 
showing  what  principal  property  is  represented  thereby  and  how  the  ac- 
counts have  been  built  up  from  year  to  year  for  a  reasonable  time  past  if 
not  from  the  inception  of  the  business.  The  information  derived  therefrom 
is  valuable  only  in  indicating  the  progressive  policy  of  the  concern,  the 
extent  to  which  it  reinvests  undivided  surplus  in  its  plant,  6tc.  Beyond 
these  facts  the  banker  who  is  asked  for  ordinary  discounts  or  short-term 
loans  is  not  interested;  he  looks  more  to  the  quick  assets  for  his  security. 

Optional. — When  the  loan  is  greater  than  the  quick  assets  seem  to  justi- 
fy the  auditor  should  suggest  a  reliable  verification  of  the  cost  of  property 
prior  to  the  period  under  audit.  Such  action  may  become  necessary  even 
to  the  extent  of  calling  for  an  appraisement  by  disinterested  outside 
experts. 

DEFERRED  CHARGES  TO  OPERATIONS 

Under  this  heading  in  the  balance  sheet  are  grouped  such  items  as 
unexpired  insurance,  bond  discounts  applicable  to  a  future  period,  prepaid 
royalties,  experimental  charges,  etc.  After  the  clerical  accuracy  of  the 
deferred  charges  has  been  verified  the  auditor  should  satisfy  himself  that 
they  are  properly  carried  forward  to  future  operations. 

Wherever  possible,  documentary  proof  must  be  produced  in  support 
of  the  items  carried  forward,  as,  for  example,  with  unexpired  insurance  the 
policies  must  be  examined  to  verify  the  dates  of  expiration,  the  amounts 
covered,  and  the  proportion  of  the  premiums  carried  forward;  with  royal- 
ties the  agreements  must  be  examined;  with  experimental  charges  the 
vouchers  and  particulars  of  the  work  done  must  be  looked  into,  etc. 

The  examination  of  the  deferred  charges  will  usually  furnish  the  auditor 
with  valuable  information  in  regard  to  the  accounts  of  the  company,  as,  e.  g. : 


694  APPENDIX 

(i)  The  verification  of  experimental  charges  carried  forward  will 
generally  furnish  information  as  to  the  production  and  future  policy  of 
the  company. 

(2)  Royalty  vouchers  will  generally  furnish  a  check  on  the  production 
of  mines. 

(3)  An  examination  of  the  insurance  policies  will  show  if  the  properties 
are  mortgaged  or  covered  by  lien,  and  thus  be  an  additional  verification 
of  the  liability  for  mortgages  on  real  estate,  buildings,  etc.,  shown  in  the 
balance  sheet. 

(4)  The  assets  covered  by  insurance  will  be  ascertained  and  if  any 
omissions  are  discovered  they  should  be  mentioned. 

NOTES  AND  BILtS  PAYABLE 

Under  this  caption  appear  notes  payable  and  drafts  accepted.  Sched- 
ules should  be  prepared  under  the  subcaptions,  and  in  columns  headed: 

Date  of  making  the  notes  or  drafts. 
Due  dates. 
Names  of  creditors. 
Collateral  hypothecated. 
Additional  indorsers. 
Interest  accrued  to  date  of  audit. 

Notations  of  renewals  (as  information  of  this  nature  furnishes  a 
guide  to  the  state  of  the  concern's  credit). 

The  schedule  must  be  compared  with  the  notes-payable  book  and  the 
total  of  the  aggregate  must  agree  with  the  balance  of  the  ledger  account  of 
notes  payable. 

Statements  must  be  obtained  from  all  banks  and  brokers  with  whom 
the  concern  does  business,  showing  all  notes  and  drafts  discounted  or  sold 
by  them  for  the  benefit  of  the  concern.  These  statements  when  received 
must  be  checked  against  the  loans  shown  on  the  concern's  books  and  ap- 
proved in  the  minutes  of  the  company. 

Inasmuch  as  a  note  is  a  negotiable  instrument,  care  must  be  taken  to 
see  that  all  of  those  recorded  as  paid  during  the  year  under  audit  have  been 
properly  discharged,  and  the  canceled  notes  are  the  best  evidence  of  this 
fact. 

Careful  attention  should  be  given  to  the  collateral  deposited  for  loans, 
and  statements  as  to  the  existence  of  such  collateral  should  be  obtained 
from  the  holders  thereof.  Such  hypothecation  of  any  of  the  concern's 
assets  should  be  accounted  for  on  the  balance  sheet. 


UNIFORM  ACCOUNTING  695 

When  practicable  the  auditor  might  suggest  to  the  client  the  advisabil- 
ity of  drawing  notes  payable  on  blanks  bound  in  a  book,  like  a  check  book, 
with  a  stub  for  each  blank,  the  blank  and  the  stub  to  bear  identical  num- 
bers. The  officer,  or  officers,  signing  the  notes  could,  in  such  case,  initial 
the  stub  as  a  certificate  to  the  amounts,  payees,  and  terms  of  the  notes 
issued.  If  this  were  done,  the  auditing  of  bills  payable  would  be  greatly 
facilitated. 

ACCOUNTS  PAYABLE 

A  list  of  balances  due  on  open  accounts  must  be  prepared  and  carefully 
checked  with  the  ledger  accounts,  care  being  taken  to  see  that  no  open 
account  on  the  ledger  has  been  omitted  from  the  list.  It  should  be  ascer- 
tained that  the  balances  represent  specific  and  recent  items  only.  When 
any  account  does  not  appear  regular  a  statement  from  the  creditor  should 
be  obtained.  If  there  are  many  such  accounts  in  dispute,  and  they  amount 
to  so  large  a  sum  as  to  affect  appreciably  the  total  of  current  liabilities,  the 
general  causes  for  the  disputes  should  be  inquired  into  and  note  made  of 
the  matter  for  the  consideration  of  the  banker. 

In  concerns  with  modern  voucher  systems  accounts  payable  are  easily 
verified,  as  all  liabilities  are  then  included  in  the  books  when  incurred. 
Care  should  be  taken,  however,  to  see  that  all  goods  received  on  the  last 
day  of  the  fiscal  period,  as  shown  by  the  receiving  records,  and  also  all 
goods  that  were  in  transit  and  belonged  to  the  concern  on  that  date,  are 
included  as  liabilities,  and  the  corresponding  assets  included  in  the  inven- 
tories. This  test  is  necessary,  as  an  increase  in  the  accounts  payable  may 
have  a  very  important  bearing  on  the  financial  position  of  the  concern  if 
the  cash  on  hand  is  small. 

Monthly  expenses  outstanding  can  usually  be  ascertained  by  a  com- 
parison of  the  expenses  of  the  last  month  of  the  fiscal  period  with  previous 
months,  and  those  of  the  year  with  the  previous  year.  The  voucher  record 
should,  however,  be  examined  for  the  months  subsequent  to  the  close  of 
the  fiscal  year,  in  case  any  expenses  included  therein  are  applicable  to  the 
fiscal  period  under  audit. 

When  a  first-class  voucher  system  is  not  in  operation  the  auditor  must 
take  additional  precautions  to  satisfy  himself  that  all  liabilities  are  included 
in  the  accounts,  among  which  may  be  mentioned: 

(i)  Payments  made  in  the  months  subsequent  to  the  date  of  the  fiscal 
period  as  shown  by  the  cashbook,  which  should  be  carefully  scrutinized  to 
see  that  none  of  them  is  applicable  to  the  period  under  review. 

(2)  The  file  of  bills  not  vouchered  or  entered  on  the  books  should  be 
examined  to  see  that  none  of  them  belongs  to  the  period  under  audit. 


696  APPENDIX 

(3)  A  careful  perusal  of  the  minutes  of  a  company  may  further  assist 
the  auditor  in  determining  liabilities. 

When  a  company  has  large  purchase  contracts  in  force  for  future  de- 
liveries they  should  be  examined,  for  if  the  contract  prices  are  greater  than 
market  prices,  it  might  be  necessary  to  set  up  a  reserve  for  this  loss. 
Any  debit  balance  due  to  advance  payments  on  such  contracts  or  to 
any  other  cause  should  be  shown  on  the  balance  sheet  under  a  separate 
heading. 

If  the  business  under  audit  is  one  where  there  is  any  possibility  of  goods 
having  been  received  on  consignments,  and  part  or  all  of  such  goods  having 
been  sold  without  a  liability  therefor  having  been  shown  in  the  books,  the 
auditor  must  use  all  due  diligence  to  cover  the  point  fully.  This  may 
readily  happen,  as  consignment  accounts  are  usually  treated  as  memo- 
randa only. 

If  inquiry  develops  the  fact  that  goods  have  been  received  on  consign- 
ment, all  records  in  connection  therewith  should  be  called  for.  If  the  goods 
have  all  been  sold,  the  consignor's  account  should  show  the  full  amount 
due,  and  if  the  debt  is  a  current  one,  the  amount  will  appear  among  ac- 
counts payable  due  to  trade  creditors.  Where  only  part  of  the  goods  have 
been  sold,  the  net  proceeds  due  to  the  consignors  should  be  shown  on  the 
balance  sheet  under  the  caption  of  "Accounts  payable  consignors." 

As  an  additional  precaution  against  the  omission  of  liabilities  a  certifi- 
cate should  be  obtained  from  the  proper  officer  or  member  of  the  concern 
stating  that  all  outstanding  liabilities  for  purchases  and  expenses  have  been 
included  in  the  accounts  of  the  period  under  review  or  of  former  periods. 
In  many  cases  it  is  also  advisable  to  obtain  a  certificate  from  the  president 
stating  that  all  liabilities  for  legal  claims,  infringements  of  patents,  claims 
for  damages,  bank  loans,  etc.,  have  been  included,  as  he  may  be  the  only 
executive  officer  of  the  company  to  know  the  extent  of  such  obligations. 

CONTINGENT   LIABILITIES 

It  is  not  enough  that  a  balance  sheet  shows  what  must  be  paid;  it 
should  set  forth  with  as  much  particularity  as  possible  what  may  have  to 
be  paid.  It  is  the  duty  of  an  auditor  who  makes  a  balance-sheet  audit  to 
discover  and  report  upon  liabilities  of  every  description,  not  only  liqui- 
dated debts  but  possible  debts.  The  following  are  the  usual  forms  under 
which  contingent  liabilities  will  be  found: 

Indorsements. — Inquiry  of  the  officers  or  partners  of  the  concern  should 
be  made  as  to  whether  any  indorsement  of  outside  paper  has  been  made 
and  as  to  any  security  received  to  protect  the  concern.     Such  inquiry 


UNIFORM  ACCOUNTING  697 

should  be  particularly  strict  if  it  is  known  that  any  of  the  officers  or  part- 
ners are  interested  in  other  enterprises. 

Guaranties. — Similar  action  should  be  taken  in  the  matter  of  guaranties. 

Unfulfilled  contracts. — Contracts  to  accept  the  delivery  of  goods  con- 
tracted for  before  the  date  of  the  balance  sheet,  may  call  for  the  payment 
of  large  sums  of  money  within  a  short  time.  In  the  case  of  raw  materials, 
for  a  manufacturer,  this  might  be  a  perfectly  legitimate  reason  for  seeking 
a  temporary  loan  pending  production  and  sale,  but  for  a  merchant  whose 
balance  sheet  shows  a  large  stock  of  goods  on  hand,  it  might  indicate  a  real 
liability  impending  with  assets  of  a  doubtful  character  to  offset  it.  In 
every  audit,  therefore,  the  auditor  should  call  for  copies  of  all  orders  for 
future  delivery,  and  if  such  orders  call  for  stock  in  excess  of  the  current  and 
reasonable  prospective  demand,  mention  should  be  made  on  the  balance 
sheet  and  a  report  submitted,  the  details  depending  upon  the  circumstances 
of  each  particular  case. 

Items  other  than  those  arising  from  the  specific  hypothecation  of 
current  assets  to  be  listed  under  item  20  should  appear  as  a  footnote  on  the 
liability  side  of  the  balance  sheet,  the  total  amounts  being  stated  for  each 
subheading  and  such  additional  report  made  as  will  convey  clear  informa- 
tion to  the  banker. 


ACCRUED  LIABILITIES 

Under  this  caption  are  grouped  such  items  as  interest,  taxes,  wages, 
etc.,  which  have  accrued  to  the  end  of  the  period  under  audit,  but  are  not 
due  and  payable  until  a  later  date.  The  verification  of  such  items  can  be 
accurately  made  from  the  books  and  records.  Special  attention  may  be 
directed  to  the  following: 

Interest  payable. — Many  of  the  liabilities  which  appear  on  a  balance 
sheet  carry  interest.  Such  items  as  bonds  and  notes  payable  are  obvious, 
but  the  auditor  should  also  consider  the  possibility  of  accounts  also  bearing 
interest,  as  enough  book  accounts,  when  past  due,  do  bear  interest  to  war- 
rant inquiry  being  made.  Loan  accounts  of  partners  and  officers  of  cor- 
porations almost  invariably  bear  interest;  also  judgments,  overdue  taxes, 
and  other  liens. 

Taxes. — The  amount  of  accrued  State  and  local  taxes  can  be  ascer- 
tained from  an  examination  of  the  latest  tax  receipts ;  though  in  some  cases, 
as  the  period  for  which  the  taxes  are  paid  is  not  shown  on  the  face  of  the 
receipt,  it  may  be  necessary  to  make  inquiries  of  the  proper  taxing  authori- 
ties as  to  the  period  covered. 

Under  the  Federal  income  tax  law  a  tax  of  2  per  cent  is  imposed  upon 


698  APPENDIX 

the  net  profits  of  a  corporation,  which  must  be  paid  even  if  the  corporation 
is  dissolved  before  the  end  of  the  vear  during  which  the  tax  is  imposed. 
As  the  tax  is  specifically  based  upon  the  net  profits  of  a  particular  period, 
although  payable  some  months  thereafter,  the  tax  accrues  throughout  the 
specified  period,  and  if  a  net  profit  is  disclosed  upon  the  closing  of  the  books 
at  any  date  during  the  year,  a  reserve  of  2  per  cent  must  be  shown  on  the 
balance  sheet  as  an  accrued  tax. 

Wages. — Where  the  date  of  the  balance  sheet  does  not  coincide  with 
the  date  to  which  the  last  pay  roll  of  the  period  under  audit  has  been  cal- 
culated, the  amount  accrued  to  the  date  of  the  balance  sheet  must  be 
ascertained  and  entered  as  a  liability,  unless  such  amount  is  trifling.  It 
will  suffice  to  take  the  proportion  of  a  full  week's  pay  roll  (six  days)  with- 
out reference  to  possible  daily  variations. 

Water  rates,  etc. — Where  bills  for  such  expenses  as  water,  gas,  etc.,  are 
not  rendered  monthly,  the  auditor  must  enter  the  accrual  of  the  proper 
proportion  since  the  last  bill  as  a  liability. 

Traveling  expenses  and  commissions. — It  is  important  to  note  whether 
the  accounts  of  all  traveling  salesmen  have  been  received  and  entered 
before  the  books  are  closed.  The  auditor  should  secure  a  list,  and  if  any 
report  was  not  so  entered,  provision  should  be  made  for  it  unless  the 
amount  is  likely  to  be  trifling. 

Ample  provision  should  be  made  for  all  commissions  eventually  pay- 
able on  sales  which  have  been  billed  to  customers.  As  commissions  are 
frequently  not  payable  to  salesmen  until  the  sales  have  been  collected  from 
the  customers,  accrued  commissions  are  often  omitted  from  the  books. 
As  they  must,  however,  be  paid  out  of  the  proceeds  of  the  sales  on  which 
the  full  profit  has  already  been  taken  into  the  accounts,  they  should  be  set 
up  as  an  accrued  liability. 

Legal  expense. — All  concerns  have  more  or  less  litigation.  Before  the 
books  are  closed  the  lawyers  should  be  requested  to  send  in  a  bill  to  date. 
If  one  is  not  found,  the  auditor  should  ascertain  the  amount,  if  any,  prob- 
ably due  and  set  it  up  as  an  accrued  liability. 

Damages. — If  the  concern  is  insured  against  liability  for  damages  to 
employees  or  the  public,  a  proportion  of  the  premiums  paid  in  advance 
for  the  unexpired  time  covered  by  the  insurance  will  appear  in  "  Deferred 
charges."  But  there  may  be  claims  or  suits  for  other  damages  not  covered 
by  insurance,  and  where  the  auditor  finds  any  evidence  which  leads  him 
to  suspect  there  may  be  liability  of  this  nature  he  should  insist  upon  being 
informed  of  all  the  facts.  He  can  then  form  an  opinion  as  to  the  amount 
that  should  be  set  up  as  an  accrued  liability,  or,  if  the  outcome  is  uncertain, 
as  a  reserve  against  possible  loss. 


UNIFORM  ACCOUNTING  699 

BONDED  AND  MORTGAGE  DEBT 

A  copy  of  the  mortgages  must  be  examined  and  the  terms  thereof 
noted.  The  amount  of  bonds  registered,  issued,  and  in  treasury,  rate  of 
interest,  and  duration  of  the  bonds,  should  be  shown  on  the  face  of  the 
balance  sheet.  A  certificate  should  be  obtained  from  the  trust  company 
certifying  the  amount  of  bonds  outstanding,  etc.,  as  verification  of  the 
liability  stated  in  the  balance  sheet.  The  interest  on  the  bonds  outstand- 
ing, shown  in  the  balance  sheet,  should  be  calculated  and  reconciled  with 
the  interest  on  bonds,  as  shown  in  the  profit  and  loss  account. 

Sinking-fund  provisions  in  mortgages  should  be  carefully  noted  and 
care  should  be  taken  to  see  that  they  are  provided  for  in  the  accounts  of 
the  company,  and  any  default  noted  in  the  balance  sheet. 

Bonds  redeemed  during  the  period  or  previously  should  be  examined 
to  see  that  they  have  been  properly  canceled,  or,  if  they  have  been  de- 
stroyed, a  cremation  certificate  should  be  obtained  from  the  trustees. 

Mortgages  sometimes  stipulate  that  the  current  assets  must  be  main- 
tained at  a  certain  amount  in  excess  of  the  current  liabilities,  and  the  audi- 
tor must  give  due  consideration  to  such  matters  and  any  other  stipulation 
in  regard  to  the  accounts,  or  any  audit  thereof,  that  may  be  referred  to  in 
the  trust  deed,  and  see  that  they  have  been  complied  with. 

Mortgages. — As  a  mortgage  derives  its  chief  value  from  the  fact  that 
upon  registry  it  becomes  a  lien,  the  auditor  should  verify  the  existence  of 
such  an  obligation  by  inspecting  the  public  records,  not  only  with  reference 
to  such  as  may  be  found  on  the  company's  books,  but  also  any  that  may 
still  appear  on  the  public  records  as  unsatisfied.  If  the  auditor  lacks  the 
necessary  facilities  for  making  a  search  it  will  be  worth  his  while  to  arrange 
with  a  local  lawyer  or  title  company  whereby,  for  a  small  fee,  any  mort- 
gages or  judgments  entered  against  the  concern  under  audit  will  be  re- 
ported to  him. 

In  any  event  the  auditor  must  verify  the  amount  as  recorded  in  the 
account,  the  rate,  the  due  date,  and  the  property  covered  thereby. 

It  should  be  borne  in  mind  that  a  payment  on  account  of  a  mortgage 
must  be  recorded  or  the  entire  amount  will  remain  as  an  encumbrance 
on  the  property.  Therefore,  if  payments  on  account  appear,  the  auditor 
should  ascertain  if  they  have  been  so  recorded;  if  not  the  fact  should  be 
noted  on  the  balance  sheet. 

Judgments. — The  same  procedure  should  be  followed  in  verifying  judg- 
ments as  in  verifying  mortgages.  As  many  business  men  consider  that  the 
entry  of  an  invoice  is  an  admission  of  liability,  and  will  not  permit  the 
entry  of  a  claim  which  they  propose  to  fight,  it  is  sometimes  difficult  for  an 


700  APPENDIX 

auditor  to  find  any  evidence  of  such  liens.  Even  admitting  the  fact,  they 
may  still  refuse  to  allow  the  judgment  to  be  entered  on  the  books  as  a 
liability,  in  which  case  it  is  proper  for  the  auditor  to  include  it  as  a  foot- 
note on  the  balance  sheet  as  a  contingent  liability. 

Unpaid  interest. — When  considering  the  matter  of  liens  it  should  be 
noted  that  interest  unpaid  is  a  lien  as  well  as  unpaid  principal,  so  where  the 
auditor  finds  evidence  of  interest  on  liens  being  in  default,  he  should  add  it 
to  the  principal  in  each  case. 

CAPITAL   STOCK 

As  a  rule  trust  companies  are  the  transfer  agents  for  the  capital  stock 
of  large  corporations  and  for  verification  purposes  it  is  sufliicient  to  obtain 
letters  from  them  certifying  to  the  capital  stock  outstanding. 

Where  companies  issue  their  own  stock,  the  stock  registers  and  stock 
certificate  books  should  be  examined  and  compared  with  the  lists  of  out- 
standing stockholders. 

On  the  balance  sheet  each  class,  if  more  than  one,  of  stock  must  be 
stated,  giving  amount  authorized,  issued,  and  in  treasury,  if  any.  In  the 
case  of  companies  with  cumulative  preferred  stocks  outstanding  a  note  must 
be  made  in  the  balance  sheet  of  the  dividends  accrued  but  not  yet  declared. 

If  stock  has  been  sold  on  the  installment  plan,  the  auditor  should  as- 
certain that  the  calls  have  been  promptly  met  and  whether  any  are  in 
arrears.  If  special  terms  have  been  extended  to  any  stockholder,  approval 
of  the  board  of  directors  is  necessary  and  the  minutes  should  be  examined 
accordingly. 

If  any  stock  has  been  sold  during  the  period  under  audit,  the  auditor 
should  verify  the  proceeds  of  the  sales. 

SURPLUS 

The  auditor  should  give  consideration  to  the  surplus  at  the  beginning 
of  the  period.  This  item  represents  the  accumulated  profits  prior  to  the 
beginning  of  the  fiscal  period  under  review,  and  should  be  compared  with 
the  surplus  shown  on  the  balance  sheet  of  the  previous  year,  and  with  the 
ledger  account,  to  see  that  it  corresponds,  and  if  it  does  not,  a  reconcilia- 
tion statement  should  be  prepared  giving  full  details  of  the  differences. 

PROFIT  AND   LOSS 

The  auditor  should  obtain  the  profit  and  loss  statement  for  three  years, 
at  least,  including  the  period  under  audit,  and  after  verifying  them  by 


UNIFORM  ACCOUNTING  701 

comparison  with  the  ledger  account,  prepare  a  statement  in  comparative 
form.  This  comparison  will  furnish  valuable  information  to  the  banker  as 
to  the  past  progress  of  the  concern  under  audit. 

A  satisfactory  form  of  profit  and  loss  account  is  annexed  hereto,  but 
any  other  form  giving  substantially  similar  information  is  acceptable. 

While  it  would  be  impracticable  in  an  ordinary  balance-sheet  audit, 
and,  at  the  same  time,  somewhat  useless  to  make  a  detailed  check  of  all 
the  transactions  entering  into  the  composition  of  the  profit  and  loss  ac- 
count, there  are  certain  main  principles  to  be  kept  in  view  which  are 
briefly  outlined  below. 

SALES 

Whenever  it  is  possible,  the  quantities  sold  should  be  reconciled  with 
the  inventory  on  hand  at  the  beginning  of  the  period,  plus  the  production, 
or  purchases,  during  the  period,  less  the  inventory  on  hand  at  end  of  the 
period. 

Where  a  good  cost  and  accounting  system  is  in  force,  the  sales  records 
will  very  probably  be  in  good  shape,  but  nevertheless,  the  auditor  should 
satisfy  himself  from  the  shipping  records  that  the  sales  books  were  closed 
on  the  last  day  of  the  fiscal  year,  and  that  no  goods  shipped  after  that  date 
are  included  in  the  transactions. 

When  an  audit  is  being  made  for  the  first  time,  the  auditor  should 
satisfy  himself  that  the  sales  at  the  beginning  of  the  period  were  recorded 
in  accordance  with  the  dates  of  shipments.  Such  verifications  can  be 
made  conveniently  by  a  direct  comparison  of  the  shipping  memoranda 
with  the  invoices  billed. 

Allowances  to  customers  for  trade  discounts,  outward  freights,  reduc- 
tions in  prices,  etc.,  should  be  deducted  from  the  sales  in  the  profit  and 
loss  account,  as  the  amount  of  net  sales  is  the  only  figure  of  interest  to  the 
bankers. 

The  future  bookings  at  the  close  of  the  fiscal  year  should  be  looked  into, 
as  a  comparison  of  orders  on  hand  with  corresponding  periods  of  other 
years  furnishes  the  bankers  with  an  idea  of  the  concern's  business  outlook. 

COST  OF   SALES 

The  inventory  at  the  beginning  of  the  period,  plus  purchases  during  the 
period,  less  inventory  at  the  end  of  period,  gives  the  cost  of  sales.  In  a 
manufacturing  concern  the  factory  cost  of  production  takes  the  place  of 
purchases.  These  items  will  have  already  been  verified  in  auditing  the 
balance  sheet,  but  nevertheless  care  should  be  taken  to  see  that  this  head- 


702  APPENDIX 

ing  has  not  been  made  a  dumping  ground  for  charges  which  would  be  more 
properly  embraced  under  the  heading  of  special  charges.  The  composition 
of  the  items  entering  into  the  cost  of  sales  should  be  traced  in  totals  into 
the  cost  ledgers  or  accounts. 

GROSS   PROFIT   ON   SALES 

This  is  obtained  by  deducting  the  cost  of  sales  from  the  net  sales.  The 
ratio  of  gross  profits  to  net  sales  should  be  calculated  and  compared. 

SELLING,   GENERAL  AND  ADMINISTRATIVE   EXPENSES 

Under  these  general  headings  should  be  set  down  the  expenses  itemized 
to  correspond  with  the  titles  of  the  ledger  accounts  kept  in  each  division. 
In  checking  the  totals  of  each  account  with  the  statement  for  the  period 
under  audit,  special  attention  to  credits  in  these  accounts  should  be  given 
to  see  that  none  have  been  made  for  the  sale  of  capital  assets  and  for  other 
items  which  should  not  appear  in  expense  accounts.  The  percentages  of 
the  totals  of  each  division  and  of  the  aggregate  total  to  net  sales  should  be 
calculated  for  each  year  for  comparison. 

NET  PROFIT   ON   SALES 

This  is  obtained  by  deducting  the  aggregate  total  of  the  selling,  general, 
and  administrative  expenses  from  the  gross  profit  on  sales,  and  shows  the 
net  earnings  of  the  concern  on  its  real  business.  Ratio  to  sales  should  be 
calculated  for  each  year  for  comparison. 

OTHER  INCOME 

Under  this  heading  is  embraced  any  income  that  may  be  derived  from 
sources  outside  of  sales,  such  as  income  from  investments,  interest,  dis- 
counts, etc.  Schedules  should  be  prepared  of  each  item,  and  the  auditor 
should  satisfy  himself  of  their  accuracy  and  of  the  propriety  of  including 
them  as  income. 

DEDUCTIONS   FROM   INCOME 

Under  this  heading  are  grouped  such  items  as  interest  on  bonded  debt, 
interest  on  notes  payable,  etc.  The  same  procedure  of  verification  as  in 
the  case  of  other  income  should  be  followed. 


UNIFORM  ACCOUNTING  7^3 

NET  INCOME — PROFIT  AND   LOSS 

Addihg  other  income  to  gross  income  and  deducting  deductions  from 
income  gives  the  net  income  or  profit  and  loss  for  the  period,  which  is  the 
amount  that  should  be  carried  to  the  surplus  account. 

SURPLUS  ADDITIONS   AND  DEDUCTIONS 

Items  of  unusual  or  extraordinary  profit  which  do  not  belong  strictly 
to  the  period  under  audit,  or  can  not  be  said  to  be  the  legitimate  result  of 
the  ordinary  transactions  of  the  concern,  should  be  entered  here  and  veri- 
fied with  the  surplus  account.  Similarly,  deductions  should  be  treated. 
Also  dividends  declared  should  be  entered  in  the  surplus  account  and  as 
an  item  under  this  caption,  inasmuch  as  it  is  the  usual  custom  to  declare 
dividends  "from  net  earnings  and  surplus."  After  adding  special  credits 
to  and  deducting  special  charges  from  the  net  income  we  have  the  total 
profit  and  loss  for  the  whole  period  from  all  sources  which,  added  to  the 
surplus  balance  at  the  beginning  of  the  period,  gives  us  the  surplus  at  the 
end  of  the  period,  which  should  agree  with  the  surplus  as  stated  on  the 
balance  sheet. 

GENERAL 

These  instructions  cover  audits  of  small  or  medium-sized  concerns. 
In  large  concerns  having,  for  instance,  tens  of  thousands  of  accounts  or 
notes  receivable,  the  detail  procedure  suggested  would  be  impracticable, 
and  internal  check  should  make  it  unnecessary.  In  such  cases  only 
tests  can  be  made,  but  the  auditor  must  always  be  prepared  to  justify 
his  departure  from  a  complete  program  by  showing  that  the  purposes 
sought  to  be  accomplished  thereby  have  been  adequately  effected  by  his 
work. 

Any  extensive  clerical  work,  such  as  preparations  of  lists  of  notes  receiv- 
able, etc.,  should  be  performed  by  the  client's  staff,  so  as  to  avoid  unneces- 
sary employment  of  professional  staff  in  merely  clerical  work  and  conse- 
quent undue  expense. 

FORM   OF   CERTIFICATE 

The  balance  sheet  and  certificate  should  be  connected  with  the  accounts 
in  such  a  way  as  to  ensure  that  they  shall  be  used  only  conjointly.  This 
rule  applies  also  to  any  report  or  memorandum  containing  any  reserva- 
tions as  to  the  auditor's  responsibility ;  any  qualification  as  to  the  accounts, 


704 


APPENDIX 


or  any  reference  to  facts  materially  affecting  the  financial  position  of  the 
concern. 

The  certificate  should  be  as  short  and  concise  as  possible,  consistent 
with  a  correct  statement  of  the  facts,  and  if  qualifications  are  necessary 
the  auditor  must  state  them  in  a  clear  and  concise  manner. 

If  the  auditor  is  satisfied  that  his  audit  has  been  complete  and  conforms 
to  the  general  instructions  of  the  Federal  Reserve  Board,  and  that  the 
balance  sheet  and  profit  and  loss  statement  are  correct,  or  that  any  minor 
qualifications  are  fully  covered  by  the  footnotes  on  the  balance  sheet,  the 
following  form  is  proper: 

I  have  audited  the  accounts  of  Blank  &  Co.  for  the  period  from 

to and  I  certify  that  the  above  balance  sheet  and 

statement  of  profit  and  loss  have  been  made  in  accordance  with  the  plan  sug- 
gested and  advised  by  the  Federal  Reserve  Board  and  in  my  opinion  set  forth 
the  financial  condition  of  the  firm  at and  the  results  of.  its 

operations  for  the  period. 

(Signed)     A.  B.  C. 

[FORM  FOR  PROFIT  AND  LOSS  ACCOUNT.] 
Comparative  statement  of  profit  and  loss  for  three  years  ending 19 .  . . 


. 

Year  ending — 

19— 

19— 

19— 

$ 

$ 

$ 

Net  sales                                                                              

Inventory  beginning  of  year                                                  

rTrn<;<5  nrnfit  nn  «;alp<;                                                                                 .  .  . 

Selling  expenses  (itemized  tc  correspond  with  ledger  accounts 
kept)  .                                              

General  expenses  (itemized  to  correspond  with  ledger  accounts 
keot) 



UNIFORM  ACCOUNTING 


705 


Year  ending- 

- 

19— 

19— 

19— 

Administrative  expenses  (itemized  to  correspond  with  ledger 
accounts  kept)  .                                 

$ 

$ 

$ 

Tntal  aflmini<;trativp  pxripir^p 

Other  income: 

Deductions  from  income: 
Interest  on  bonded  debt 

Total  deductions 

Add  special  credits  to  profit  and  loss ...            ... 

Profit  and  loss  for  period  .            ... 

Dividends  paid 

Surplus  ending  of  period 

[For  form  of  Balance  Sheet,  see  pages  372,j/j. 
VOL.  I — 45 


APPENDIX  B 

EXAMPLE  OF  PROVISIONS  CONTAINED  IN  A 
PREFERRED  STOCK  AGREEMENT 

The  stock  certificates  of  a  company  incorporated  in  1921,  contain  the 
following  definitions  and  provisions: 

1.  '*  Gross  Income"  of  any  fiscal  period  shall  be  the  gross  sales  of  such 
period  plus  the  income  received  from  interest,  rentals,  commissions,  divi- 
dends, and  all  other  current  revenues  of  every  description.  The  company 
may  set  up  reserves  out  of  the  gross  income  of  any  fiscal  period  for  antici- 
pated charges  reasonably  accruing  but  not  capable  of  being  definitely  as- 
certained, but  any  excess  of  such  reserves  set  up  after  December  27,  1919, 
and  remaining  after  such  charges  shall  have  been  definitely  ascertained, 
shall  be  included  in  the  gross  income  for  the  fiscal  period  in  which  such 
ascertainment  shall  have  been  made.  Gross  income  of  any  fiscal  period 
shall  further  include  any  other  net  credits  made  during  such  period  by  the 
Company  direct  to  surplus  or  to  profit  and  loss,  or  to  any  other  account 
which  would  make  such  net  credits  available  for  dividends  on  junior  stock, 
whether  such  net  credits  arise  from  the  sale  of  property,  adjustments  of 
reserves,  or  otherwise,  but  not  if  such  net  credits  arise  from  the  adjust- 
ment of  reserves  set  up  on  or  before  December  27,  191 9. 

2.  "Net  Income"  shall  be  the  balance  of  income  remaining  after  de- 
ducting from  the  gross  income  of  any  fiscal  period  all  returned  sales;  allow- 
ances and  discounts  to  customers;  raw  materials,  supplies,  and  direct  and 
indirect  labor  used  in  the  manufacture  of  finished  products  sold,  selling, 
general,  and  administrative  expenses;  reserves  for  insurance  and  inventory 
depreciation;  all  interest  accrued  on  borrowed  money;  reserves  for  all 
current  taxes,  accrued  and  estimated;  bonuses  to  general  executive  officials 
of  the  Company  not  exceeding  in  the  aggregate  their  total  salaries ;  bonuses 
to  employees;  bad  accounts  written  off;  reserves  for  doubtful  accounts; 
and  reserves  for  maintenance  and  depreciation  of  buildings  and  equipment 
at  such  percentages  of  the  valuation  thereof  as  the  Company  may  from 
time  to  time  deem  advisable,  but  in  no  event  at  a  rate  of  less  than  2  per 
cent  of  the  value  thereof  for  all  buildings,  5  per  cent  01  the  value  thereof  for 
all  fixed  machinery  and  equipment,  and  20  per  cent  of  the  value  thereof 
for  all  automobiles,  trucks,  and  wagons;  and  any  other  expenses,  losses, 
and  charges. 

706 


PREFERRED  STOCK  AGREEMENT  707 

3.  "Fixed  Assets"  shall  be  the  investment  in  plant  and  equipment, 
including  land  and  buildings,  plus  all  other  assets  of  the  Company  except 
only  (a)  current  assets  and  (b)  patents,  trade-marks,  trade-names,  good- 
will, and  similar  assets.  The  investment  in  plant  and  equipment  owned  on 
November  1 7, 1916,  and  included  in  the  appraisal  of  that  date,  shall  never 
be  valued  at  more  than  one  million,  five  hundred  thousand  (1,500,000) 
dollars;  and  other  plant  and  equipment  then  owned,  as  well  as  plant  and 
equipment  subsequently  bought  or  installed,  shall  never  be  valued  at  more 
than  cost,  and  both  shall  be  taken  after  deducting  the  reserve  for  depre- 
ciation. The  valuations  placed  upon  the  fixed  assets  of  the  Company  at 
the  beginning  of  any  accounting  period,  in  determining  the  amount  of  its 
net  tangible  assets,  as  hereinafter  defined,  shall  be  used  in  determining  the 
amount  of  the  reserve  for  the  same  period  for  the  maintenance  and  depre- 
ciation of  buildings  and  equipment  provided  for  in  the  foregoing  paragraph 
defining  "net  income." 

4.  "Current  Assets"  shall  include: 

(a)  Cash  on  hand  and  in  bank,  including  cash  in  the  sinking  fund ; 
good  and  collectible  notes,  accounts,  bills,  and  trade  accept- 
ances receivable,  including  accrued  interest  and  rents  and 
royalties  receivable,  but  not  including  receivables  representing 
advances  made  to  finance  the  acquisition  of  fixed  assets;  and 
prepaid  insurance,  interest,  and  taxes,  and  other  prepay- 
ments. 

(b)  Manufactured  products;  products  in  process  of  manufacture, 
and  materials  and  supplies,  such  products,  materials,  and 
supplies  to  be  valued  on  the  basis  of  actual  cost,  or  market 
value,  whichever  is  lower. 

(c)  Bonds  of  the  United  States  Government  at  not  exceeding 
their  market  value. 

(d)  Certificates  of  indebtedness  of  the  United  States  Government 
at  not  exceeding  their  par  value. 

(e)  Other  readily  marketable  securities  paying  regular  interest 
or  dividends,  valued  at  not  more  than  the  market  value  there- 
of (excluding  bonds  or  stocks  issued  by  the  company  or  by  a 
constituent  company,  or  issued  by  a  corporation  of  which 
the  Company  or  constituent  company  shall  at  the  time  own  or 
control,  directly  or  indirectly,  a  majority  of  the  capital  stock). 

5.  "Current  Liabilities"  shall  include:  accounts,  bills,  notes,  and  ac- 
ceptances payable,  maturing  within  one  year  after  their  date;  loans  from 


708  APPENDIX 

banks  and  bankers;  salaries,  wages,  interest,  rents,  royalties,  and  taxes 
accrued,  including  income  and  excess  profits  taxes. 

6.  "Net  Current  Assets"  shall  be  the  current  assets,  less  the  current 
liabilities. 

7.  "Net  Tangible  Assets"  shall  be  the  net  current  assets  plus  the  fixed 
assets  less  any  debts  not  included  among  the  current  liabilities,  including 
purchase  money  mortgages  and  debentures. 

8.  "Constituent  Company"  shall  be  taken  to  mean  any  corporation 
or  association  of  which  at  least  seventy-five  (75)  per  cent  of  the  shares 
having  ordinary  voting  power  (including  directors'  qualifying  shares) 
are  owned  by  the  Company. 

9.  "Fiscal  Period"  shall  be  one  or  more  accounting  periods,  at  the 
option  of  the  company,  but  shall  never  exceed  fifty-three  weeks. 

Definitions  i  and  2  refer  to  a  consolidated  statement  of  income  of  the 
Company  and  all  its  constituent  companies,  after  eliminating  all  inter- 
company items  and  the  proportion  of  the  net  income  of  constituent  com- 
panies not  accruing  to  the  Company. 

Definitions  3  to  7,  inclusive,  refer  to  a  consolidated  balance  sheet  of  the 
Company  and  all  its  constituent  companies,  after  eliminating  all  inter- 
company items.  In  any  consolidation  of  accounts  made  under  these 
definitions,  the  addition  to  net  tangible  assets  in  respect  of  the  net  tangible 
assets  of  any  constituent  company  shall  in  no  case  exceed  the  excess  of  the 
net  tangible  assets  of  such  constituent  company  over  the  sum  of  the  par 
value  of  the  common  stock  (or  the  declared  or  stated  value  thereof,  if  any, 
in  the  case  of  common  stock  without  par  value)  of  such  constituent  com- 
pany not  owned  by  the  Company,  and  the  proportionate  interest  of  such 
unowned  common  stock  in  the  surplus  of  such  constituent  company,  and 
twice  the  par  value  of  the  preferred  stock  of  such  constituent  company  not 
owned  by  the  Company. 

Any  audit  of  the  books  and  accounts  of  the  Company  and  its  constitu- 
ent companies  made  by  a  certified  public  accountant,  and  made,  or  cer- 
tified by  such  accountant  to  have  been  made,  upon  the  basis  of  the 
definitions  in  this  article  contained,  shall  be  conclusive  upon  the  Com- 
pany and  all  holders  of  preferred  stock,  unless  and  until  such  audit  shall 
be  duly  adjudged  erroneous. 


INDEX 


Abnormal  Conditions, 

accounts  outstanding  under,  90-92 
inventory  valuations  under,  129-131,  I59 
Acceptances, 

advantages  of,  257 
discounting  of,  257 
indorsements  of,  256-258 
trade, 

not  considered  notes  receivable,  109 
Accommodation  Indorsements, 

as  liabilities,  251-255 
Accounting, 

auditor's  familiarity  with  various  meth- 
ods, 52 
distinguished  from  auditing,  i 
errors  of  principle,  23,  482 
good  practice  of,  and  good  business,  125 
investigation  of  system,  455 
knowledge  of,  essential  to  auditor,  3 
proposal  of  Federal  Reserve  Board,  679- 
705 
Accounts, 
book  of, 

knowledge  of,  by  auditor,  53 
controlling, 

postings    to    credit    of   customers'    ac- 
counts proved  through,  511 
reconcilement  with  subsidiary  records, 

61 
subsidiary  ledgers,  619 
test  of  ledger  posting  covered  by,  497, 
499,  500 
manipulation  of,  492 
nominal, 

verification  of,  511 
surplus,  279 
terminology,  296-300 
Accounts  Payable, 
as  liabilities,  225-228 
classification  of,  226 
internal  checking  of,  65 
omitted  in  report,  417 
open  accovints  in  ledger  compared  with, 
229 
Accounts  Receivable, 

acknowledgment  of  debt  from  debtor,  106 
analysis  of,  93 


Accounts  Receivable— Conr/wwerf 

anticipating  profits  not  earned,  92 

appraisal  of,  91-96 

bad  debts,  90,  580 

cash  deposited  as  security,  106 

classification  of,  62 

distinction  between  inventory  value  and, 
not  sound,  150 

effect  of  Cuban  moratorium  on,  93 

export  sales,  104 

fictitious,  100 

foreign  exchange  rates,  105 

fraud  connected  with,  515 

from  affiliated  companies,  97-99 

from  officers  or  employees,  99 

instalment  accounts,  102 

inventory  valuation,  120 

liquidating  partnership,  466 

not  current  assets,  153 

not  due  within  one  year,  100,  153 

omitted  in  report,  417 

overdue,  91-96 

pledged  or  assigned,  80,  94 

purchase  of,  79 

reserves  for,  3 1 .  90 

reserves   for  bad    debts   deducted  from, 
314 

schedule  of,  579 

separation  of  doubtful,  94 

under  abnormal  conditions,  92 

valuation  of  overdue,  91-96 

verification  of,  89 

in  balance  sheet  audit,  290-334 
in  detailed  audit,  51 5-537 
Accruals, 

detailed  audit,  49s 

expenses,  330 

notes  receivable,  no 
Adams,  H.  C,  on  Depreciation,  635 
Additions,  586,  590 

concealment  of,  215 

in  book  values  of  property,  178 
Administration  (See  "Check  system") 
Advertising, 

absorption  of  expenses  as  deferred  charges, 
446.  569 

by  auditor, 

ethical  aspect  of,  IS 

misleading,  419 


709 


7IO 


INDEX 


Affiliated  Companies, 
amounts  due  from,  97-99 
consolidated  balance  sheet,  335-347 
consolidated  income  account,  347-35 1 
Agreements, 

written,  before  making  audit,  40 
Agricultural  Implement  Dealers, 

notes  taken  for  sales,  108 
Allowances    Granted     to     Customers, 

553-556 
American  Bankers'  Association, 
endorse  certified  accounts,  34 
financial  statement,  form  of,  378-380 
American  Institute  of  Accountants, 
auditing  procedure  memorandum,  61 
condensed  income  account,  408 
members  suspended  for  failure  to  state 

amounts  due  correctly,  99 
rules  for  professional  conduct,  12 
American  Malting  Company, 

(Hutchinson  vs.  Curtiss),  146,  293,  522 
liability  of  directors,  671-677 
Amortization, 

fund  for  depreciation,  628 
of  bonds,  203,  583 
Annuity   System   for    Depreciation   of 

Leaseholds,  646 
Appreciation, 

cannot  ofTset  depreciation,  457 
included  in  costs,  140 
value  of  assets,  321 
Assets, 

analysis  of,  73 

appreciation  of,  to  offset  depreciation,  457 

capital, 

carried  at  cost,  323 

sale  of,  280,  457 
changes  in,  343 
classification  of,  73.  76-79 
contingent,  213 
current, 

accounts  receivable,  89-107 

accounts  receivable  not  included  as,  153 

business  insurance,  113 

cash,  85-89 

cash  deposits  as  security,  106 

deferred  charges,  11 5 

defined,  75 

fictitious  accounts,  100 

foreign  branches,  69 

investment  securities  not,  11 1 

investments,  temporary,  114 

Liberty  bonds,  112 

liens  on,  79 

net,  79 

notes  receivable,  107-116 

postage  stamps,  115 


Assets — Continued 
current — Continued 

pre-paid  items,  115 

ratio  of,  to  other  liabilities  and  capital, 
82 

schedule  of,  76 

securities  as  stock-in-trade,  iii 

writing  down  of,  130 
detailed  audit  of,  58i-S99 
fixed,  173-220 

arrangement  of,  on  balance  sheet,  178 

bonds,  205 

book  value,  determination  of,  178 

containers,  187 

copyright,  194 

defined,  173 

electrotypes,  190 

foreign  branches,  69 

funds  and  other  permanent  investments, 
203 

furniture  and  fixtures,  187 

good-will,  195-200 

horses,  188 

in  leased  premises,  187 

income  from  sale  of,  320 

intangible,  schedule  of,  78 

investment  securities  are.  iii 

investments  of  reserves,  202 

leaseholds,  183 

machinery  and  equipment,  185 

methods  of  aiming  at  valuation,  I77- 
179 

mines,  212 

mortgages,  205 

patents,  190-193 

patterns,  drawings,  etc.,  189       ^ 

plant  accounts,  analysis  of,  1 75-177 

real  estate,  179-184 

secret  reserves,  214-220 

sinking  funds,  200 
,  stock,  206-209 

timber  land,  212 

tools,  187 

treasury  stock,  206-208 

wagons,  automobiles,  etc.,  189 

wasting  assets  classed  as,  209 
fixed  tangible, 

schedule  of,  77 
inflation  of,  129 

listed   on   consolidated   balance   sheet 
341 
miscellaneous  schedule  of,  78 
on  balance  sheet,  71-84 
sale  of,  457 
tangible, 

defined,  174 

net  tangible  defined,  17S 


INDEX 


7I£ 


Assets — Continued 
valuation,  74 

appreciation  of,  321 

in  making  investigations,  426 

liquidating  partnership.  465 
wasting, 

depreciation,  653 

dividends  of  mining  company,  295 

valuation,  209-213 
Assignments, 

of  accounts  receivable,  80 
Auditing, 

business  man's  attitude,  2 
distinguished  from  accounting,  i 
profession  of,  6 
Auditor, 

action  of,  when  assets  are  wrongly  valued, 

219 
and  client, 

agreement  with  client  definitely  fixed,  40 

co-operation  of,  with  client,  41 

criticism  of  auditor,  54 

distinctions  of  methods  should  be  dis- 
cussed, 72 

instructions  from  client  to  auditor,  424 

legal  status  and  responsibility  of  each, 
39 

not  ethical  for  one  auditor  to  supplant 
another,  54 

procedure    when    supplanting    another 
auditor,  54 

relation  of  auditor  to  staff  of  client,  41 

relation  between,  39 

restrictions  on  use  of  reports,  418 
as  efficiency  engineer,  601 
as  expert  witnesses,  428-432 
ethics  of,  9-17 

experience  and  training  of,  5 
familiarity  with  various  lines  of  business, 

52 
fees,  43-46 

good  system  necessary  to,  48 
incompetent,  7 
knowledge  of  negotiable  instruments  law, 

235 
legal  decisions  concerning,  7-17 
legal  duty  as  to  inventories,  154 
legal  ethics  and  liabilities,  7.  9-12 
liability  for  report,  359 
liability  in  making  forecasts,  43s.  449 
restrictions  on  rights  to  examine  books, 

669 
should  express  opinion,  33 
tact  when  making  report  to  client,  42 
Audits  (See  also   "Balance  Sheet  Audits," 

"Detailed  Audits";  "Investigations"; 

"Reports") 


Audits — Continued 
advantages  of,  29-38 

as  a  proof  of  condition  of  affairs,  30 

in  fire  loss,  35 

in  partnerships,  34 

in  recovery  for  negligence,  38 

in  sale  of  business,  37 

to  public  service  corporations,  37 

to  secure  bank  loans,  33 

to  secure  surety,  35 

to  stockholders  and  the  public,  36 
compared  to  investigations,  423 
completed,  491 
contingent  liabilities,  54 
continuous,  491 
detailed  or  balance  sheet,  55 
detection  of  errors,  23-28 
detection  of  fraud,  21-23 
made  without  notice  to  cashier,  87 
payment  for,  by  client,  39 
prior,  54 

promptness  in  completing,  29 
proper  authority  for  making  determined 

beforehand,  39 
publicity  of,  36 
purposes  of,  18-28 
voucher  method,  57 
where  made,  46 

written  agreement  before  making,  40 
Automobiles, 
depreciation,  650 
valuation,  189 
Average  Cost,  135 
Average,  Weighted,  138 

B 

Bad  Debts, 

accounts  receivable,  90,  580 
notes  receivable  as,  250 
on  income  account,  313 
purchase  of  accounts  receivable,  79 
reserves  for,  251,  314 
writing  off,  94,  314 
Balance  Sheet  (See   also    "Balance  Sheet 

Audit";         "Consolidated         Balance 

Sheet") 
adjusted  to  new  capital,  376 
as  a  basis  for  bank  loans,  32 
as  an  aid  in  verifying  income,  518 
assets  and  liabilities  compared,  374 

Forms,  375 
Cleveland    Clearing    House    Association, 

374 
condensed  vs.  detailed,  371 
construction  of,  271 
contingent  liabilities  listed  on,  371 


712 


INDEX 


Balance  Sheet— Continued 

date  of, 

liabilities  created  after,  249 

on  certificate,  364 

prices  after  closing,  150-152 

transactions  occurring  after,  S4 
debts  subordinated,  224,  376 
distinction    between    liabilities    and    net 

worth,  269 
Federal  Reserve  Board, 

Form,  370,  372-373 
Federal  Reserve  Board  recommendations, 

61,  72 
forms  of,  365-381 
holding  company,  97 
influence  of  excess  profits  on,  31 
influence  of  trade  conditions  on,  152 
interdepartmental        or       intercompany 

profits,  152 
no-par  value  stock  on,  374 
omitted  items,  250 
precautions  against  separation  of  sheets 

of,  36s 
reserves    segregated    from    surplus,    268, 

374 
surplus  groupings  on,  280,  374 
value  of,  to  banker,  221 
verification  of,  29 
Balance  Sheet  Audit,  58,  71 
accounts  receivable,  89-107 

advances  or  purchase  of,  79 

from  affiliated  companies,  97-99 
assets, 

classification  of,  73,  76-79 

fixed, 173-220 

(for  full  entries  see  "Assets,  fixed") 

schedule  of,  76-79 

valuation  of,  73 
book  value  vs.  actual  values,  17S 
capital  stock,  271-278 
cash,  85-89 

compared  to  detailed  audit,  491 
contingent  liabilities,  247-266 

(for  full  entries  see  "Liabilities,  Con- 
tingent") 
costs  on,  135-144 
current  assets,  75,  116 

net  current  assets,  79 

ratio  of,  to  other  liabilities,  82 

verification  of,  79 
expenses,  324 
Federal    Reserve  Board  proposal,  61,  72, 

681-705 
fictitious  accounts,  100 
general  principles,  71 
gross  income  on,  311 
income  account,  290-334 


Balance  Sheet  Audit — Continued 
income  account — Continued 

(for  full  entries  see  "Income  account") 

importance  of,  303 
inventories,  1 17-172 

rules  for  verifying,  162-167 

variations  in,  132 
investments  at  amortized  values,  203 
liabilities,  80,  221-266 

(for  full  entries  see  "Liabilities") 
liens,  79-8 r 
limitations  of,  72 
losses,  324 

notes  receivable,  107-116 
or  detailed  audit,  consideration  of,  55 
overdrafts  on  bank  balance,  89 
period  to  be  covered,  175 
petty  cash  fund,  87 
reserves,  267-271 
surplus,  278-289 
valuation, 

method  of  arriving  at,  177-170 

rule  for,  159 
Bank, 
account, 

balancing  of,  502-509 

branch  office,  68 

"canceled"  cheques,  fraud  in,  508 

checking  of,  63 

cheques  not  returned,  509 

deposits  credited  at   a   later   date   by 
bank, 505 

deposits  should  be  made  daily,  501 

errors  by  bank  clerks,  563 

examination  of,  504 

examination  of  indorsements,  506 

examination  of  statement  or  pass-book, 
509 

interest  on,  457,  530 

money  borrowed  to  pay  deficient,  87 

monthly  reconciliations,  63 

negligence  of  depositor,  50S 

overdraft  on,  89 

reconciliation  of,  508 

reconciliation  of,  with  cash  receipts,  509 

verification,  85,  502-509 
certified  accounts  endorsed  by,  34 
contingent  liabilities,  259 
investigations  for  credit,  470-473 
negligence  of,  507 
reports  for,  353 
statements, 

examined  before  filing,  504 

monthly,  504 

of  assets  and  liabilities  from  borrowers, 
377 

verification  of,  S03 


INDEX 


713 


Bank  Checks  (See  "Cheques") 
Bank  Loans  (See  "Loans") 
Bankruptcy, 
causes  of,  479 
investigations  after,  473 
Banks, 

time  figured  on  interest,  658 
"Base"  Stock   Method  of    Inventory, 

125 
Bill, 

certified  as  evidence  of  payment,  540 
rendered  by  branch  office,  68 
Blue-Sky  Laws,  302 
Bonds, 

amortization  of,  203,  583 
as  liabilities,  236 
audit  of,  598 
discount, 

as  a  deferred  charge,  573 
examination  of  bond  ledger,  598 
interest  on,  calculation  of,  663 
mortgage,  205 
of    subsidiary    on    consolidated    balance 

sheet,  341 
premiums  received  on,  583 
reserves  for  retiring,  286 
smking  fund  for,  632 
surety, 

for  employees,  35.  459.  557 
valuation,  205 
Book  Value, 

as  basis  for  actual,  175 
Books  of  Account. 

auditor  should  have  list  of  all,  515 
director's  right  to  inspect,  667,  669 
efficiency  of,  602 
erasures  in,  603 
loose-leaf,  603 
Bradstreet  Company  Statement  Form, 

398-401 
Branch  Accounts, 
current  assets,  69 
detailed  audit  of,  585 
fixed  assets,  69 
foreign,  69 
internal, 

check  for,  67-70 
Building  Construction, 
costs,  588 
interest  paid  on  borrowed  money  for  use 

in,  589 
on  leased  land, 

depreciation  of,  646 
profit  not  included  in  costs,  589 
rate-making,  590 

salaries   of  manager    or    superintendent, 
592 


Buildings, 

demolished, 

depreciation  on,  64S 

depreciation,  644 

valuation,  179-184 
Business, 

good  practice  and  accounting,  125 


Canada, 

legal  requirements  for  reports,  420 
Cancellation  of  Orders,  261,  312,  319 

effect  of,  on  inventory  values,  160 
Capital, 

distinct  from  liabilities,  223 
distributions  of,  from  contributed  surplus, 

29s 
dividends  not  paid  out  of,  292 
expenditures,  585 
invested, 

changes  in,  344 

valuation  of,  344 
new. 

adjusted  on  balance  sheet,  376 
payment,  585 

cash  discounts  on,  587 
profits, 

defined,  309 
ratio  of  merchandise  to,  82 
receipts    from,   not    included    in    income 

account,  291 
sufficient,  450 
working. 

reserve  for,  287 
Capital  Stock, 
audit  of, 

detailed,  597 

procedure,  273.  584 
balance  sheet  audit,  271-278 
converted  into  bonds,  259 
dividend, 

reserve  fund  for,  288 
no-par  value,  274-277.  374—376 
of    subsidiary,    on    consolidated    balance 

sheet,  341 
premiums,  278,  583 

statutory  liability  of  stockholders,  213 
transfer  of,  277 
unissued,  208 
unpaid  subscriptions  not  notes  receivable. 

no 
value  of  assets  paid  in  for,  273 
Capital  Surplus,  279 
Case,  J.  H..  on  Consolidated  Balance 

Sheets,  339 
Cash, 

audit  of  alone,  not  sufficient,  56 


714 


INDEX 


Cash — Continued 
book, 

discounts  verified  in,  523 

falsification  of,  510,  512 

reconciliation  with  bank  book,  86 
deposits, 

as  security,  106 
deposits  in  bank, 

checking  methods,  63 

money  borrowed  to  complete  balance, 
87 

verification  of,  85 
discount, 

on  capital  payments,  587 

reserves  for,  90,  332 

treatment  of,  532 

verification  of,  523 
in  transit, 

verification  of,  89 
memoranda,  88 
payments, 

postings  of,  513 

verification  of,  512 
petty, 

branch  office  funds,  68 

verification,  63,  87 

vouchers  for  disbursements,  63,  546 
receipts, 

falsification  of,  510 

from  sales,  517 

verification  through  bank  deposits,  509 
remittances  by  mail, 

should  be  listed,  63 
verification  of,  85-89 
Cashier, 

audit  of  petty  cash  fund,  63 
bonding  of,  when  books  are  audited  regu- 
larly, 35 
no  access  to  certain  accounts,  63 
Certificates,     360-365     (See    also     "Re- 
ports") 
date  of, 

"as  of"  date  of  balance  sheet,  364 

transactions    occurring    after    date    of 
balance  sheet  and  before,  54 
forms,  361-364 

should  not  contain  forecasts,  450 
with  reservations,  133 
Certified  Account, 

as  a  basis  for  bank  loan,  33 
endorsed  by  American  Bankers'  Associa- 
tion, 34 
publicity  of,  36 
Check  System, 
internal, 

bank  balances,  63 

bank  deposits,  63 


Check  System — Continued 
internal — Continued 

branch  offices,  67-70 

cash  remittances,  63 

cheque  payments,  63 

collections,  66 

customer's  accounts,  66 

incoming  mail,  63 

inventory  of  stock,  67 

method  of  auditing  depends  upon,  62 

pay-rolls,  66 

petty  cash  fund,  63 

purchases,  64,  542 

sales  invoice,  66 

stock  records,  67 

transportation  charges,  64 

vacations  and  transfer    of  employees, 
67 

vouchers,  of  branch  office,  68 
Cheques, 
bank, 

all  payments  by,  513 

arrangement  of  vouchers  for  auditor,  62 

"canceled,"  fraud  in,  508 

control  of  issuing,  63 

illegal  uses  of,  501 

falsification  of,  512 

in  transit,  89 

indorsements  examined,  506 

not  returned,  509 

on  report,  417 

outstanding  at  closing  date,  63,  86 

verification  of,  512 

vouchers,  63,  539 
Clerks, 

checking  work  of,  494 
scheduling  of,  S3 
Cleveland  Clearing  House  Association, 

Balance  Sheet  Form,  374 
Client  (See  "Auditor  and  client") 
Collateral, 

cash  deposits  as|,  106 

information       concerning       not       alone 

sufficient,  471 
liens,  79 
Collections, 

falsification  of  receipts,  524-528 
fees  charged  by  bank,  563 
from  rentals,  530 
internal,  » 

check  for,  66 
not  accounted  for.  518,  524-528 
Commercial  Paper, 

rediscounts,  339 
Commissions,  242 
goods  sold  on,  520 
salesmen's,  559 


INDEX 


715 


Commitments, 

careless,  253 

for  future  delivery,  259-263 
Competition, 

considerations  of,  454 
Completed  Audit,  491 
Concealment  of  Liabilities,  233 
Condemned  Property,  45s 
Confidential  Information, 

restrictions  on  client's  use  of  reports,  418 

secured  from  competitor,  435 
Consignments, 

fraud  in  goods  sent  on,  442 

goods  received  on,  520 

in  inventory,  164 

insurance  on,  520 

liabilities  for  goods  received  on,  232 

profit  on  goods  sold,  312,  52 1 

verification  of,  519 
Consolidated  Balance  Sheet,  335-347 

bonds  of  subsidiary,  341 

book  values  for  shares  purchased,  346 

capital  stock  of  subsidiary,  341 

changes  in  invested  capital,  343 
Form,  340 

guaranties  of  subsidiaries'  obligations,  347 

majority  interests  acquired,  343 

minority  interests  shown  on,  341 

rediscounts,  339 
Consolidated  Income  Account,  347-3  Si 
Construction    (See    "Building    construc- 
tion") 
Containers, 

refunds  for  return  of,  188,  555 

valuation,  187 
Contingent  Assets   (See  "Assets,  contin- 
gent ") 
Contingent  Liabilities  (See  "Liabilities, 

contingent") 
Continuous  Audit,  491 
Contracts, 

future, 

contingent  liabilities  for,  259 
losses  in,  260,  461 

instalments  due  on,  102,  S90 
Control  (See  "Check  system") 
Controlling  Accounts  (See  "Accounts") 
Conyngton,  Thomas,  on  Dividends,  293 
Copying  Methods,  615 
Copyright, 

depreciation,  652 

royalties,  462 

valuation,  194 
Corporations, 

liabilities  of  directors,  665-677 

minute  book  as  source  of  information,  264, 
665 


Cost, 

accounting  system,  aid  m  auditing,  169 

adjustment  to  value,  144 

allocation  of,  569 

appreciation  included  in,  140 

arbitrary  methods  of  finding,  139 

average,  135 

book  vs.  market,  160 

current  operating, 

assets  partly  chargeable  to  not  fixed,  174 

defined,  13s 

does  not  include  profit,  171 

interest  not  an  element  in,  155-158 

inventory  at,  134.  138,  I59 

methods  of  finding,  139 

replacement,  142,  160 

replacements,  at   date   of   balance  sheet, 
141 

reproduction,  at  date  of  inventory.  141 

rules  for  valuation  at,  159 

specific  purchases  on  hand,  137 

use  of  values  instead  of  costs,  140 

when  market  is  higher  than,  144 
Cost  or  Market, 

fundamental  error  in,  150 

value  of  inventories,  1 26-131 
Coupons,  244 
Credit, 

extension  of, 

based  on  balance  sheet,  225 
by  banks,  assisted  by  audit,  33 
collateral  i;5.  personal  integrity,  471 
investigation  for,  470-490 

(for  full  entries  see  "  Investigations  ") 

for  allowances  and  returns,  553-556 

National    Association    of    Credit    Men's 
rules,  478 
Credit  Department,  313 
Credit  Manager, 

procedure  when  extending  credit,  477 
Credit  Reports,  377-404 

Bradstreet  Company,  398-401 

Dun,  R.  G.,  and  Company,  402-404 

Federal  Reserve  Board,  386-392 

Irving  National  Bank,  382-385 

National  Association  of  Credit  Men,  394- 
397 
Creditors, 

omitted  on  report,  417 

statements  from,  62,  228 
Cuba,  Moratorium  in,  93 
Current  Assets  (See  "Assets") 
Customers, 

accounts, 

internal  check,  66 
verification  of,  511,  S25 

credit  given  to,  verification  of,  553-556 


7i6 


INDEX 


Customs  Duties, 
charges  in  inventory, 
payment  of,  563 


164 


Damages, 

claims  for,  243 

not  contingent  liabilities,  248 
Date, 

of  balance  sheet,  transactions  occurring 

after,  54,  150,  249 
of    certification,    transactions    occurring 

before,  54 
of  detailed  audit,  auditor's  responsibility 
prior  to,  495 
Debtors,  Omitted  on  Report,  417 
Debts      (See     also     "Bad      debts,"     and 
"  Liabilities") 
subordinated,  on  balance  sheet,  224,  376 
Decisions, 

American  Malting  Company  (Hutchinson 

V.  Curtiss),  146,  293.  522 
Cliquot's  Champagne  (Muser  v.  Magone), 

131 
depreciation.  People  ex  rel.  Jamaica  Water 
Supply  Co.  V.  State  Board  of  Tax  Com- 
missioners, 622 
forgery, 

Farrell  et  al.  v.  First  National  Bank  of 

Philadelphia,  507 
Los  Angeles  Investment  Co.  v.  Home 

Savings  Bank  of  Los  Angeles,  507 
Pomona  Building  and  Loan  Association 
V.   West  Side   Trust  Co.  of    Newark, 
S07. 
in  re  Kingston  Cotton  Mill  Co.,  154 
Irish   Woolen    Co.,    Ltd.,    v.    Tyson   and 

others,  545 
legal  responsibility. 

East  Grand  Forks  v.  Steele,  11 
Smith  V.  London  Assurance  Corpora- 
tion, 12 
net  income.  306-308 
patents, 
;        Am  Ende  v.  Seabury,  486 

Rubber  Co.  v.  Goodyear,  486 
Deductions, 

from  gross  income,  311-314 
from  income  account,  324 
Deeds  of  Trust, 
net  current  assets,  79 
no  limitations  placed  on  conversion  period 
of  inventories,  153 
Defalcation  (See  "Embezzlement") 
Deferred  Charges, 
absorption  of,  446 


Deferred  Charges — Continued 

advertising,  576 

allocation  of,  569 

bond  discount,  573 

charges  to  operation,  115,  522 

doubtful  items,  574 

instalment  accounts,  102 

organization  expenses,  576 
Department  Stores, 

purchase  invoices,  65 
Departments, 

distribution  of  profits  among,  317 
Depletion,  Calculation  of,  210 
Deposits, 

from  customers,  244 

interest  time  figured  on,  658 
Depreciation  (See  also  "Valuation") 

allowance  for,  on  income  account,  326-328 

auditor's  judgment  concerning,  635 

automobiles,  650 

buildings,  644 
demolished,  645 
New  York  State  ruling,  645 

cannot  be  offset  by  appreciation,  457 

causes  of,  624 

copyright,  652 

cost  basis  for,  634 

defined,  621 

effect  of  income  tax  on,  623 

equipment,  647 

fixed  assets,  173.  622 

fixed  percentage  basis,  627 

fluctuations  in,  621 

furniture  and  fixtures,  649 

good-will,  652 

horses  and  animals,  650 

in  book  value  of  property,  178 

land,  638,  643 

leaseholds,  646 

machinery  and  equipment,  647 

maintenance,  625,  647 

methods  of  calculating,  626 

mines,  653 

new  buildings  on  leased  land,  646 

obsolescence,  637 

operating  expense,  an,  634 

patents,  652 

production  method,  631 

proper  provision  for,  31 

rate  tables,  639-643,  648-649  ^- 

repairs,  625  ...     \     a    ^ 

reserves,  2*57^09 
buildings,  183 

in  book  value  of  property,  178 
investment  of,  636 
machinery  and  equipment,  185 
theory  of,  622 


INDEX 


717 


Depreciation — Continued 

ships,  651 

sinking  fund  for  vs.  funa  for  bond  retire- 
ments, 632 

sinking  fund  method,  628-631 

small  tools,  649 

tables.  639-643.  648.  649 

timber  land,  654 

wagons,  650 

wasting  assets,  653 
Detailed  Audit, 

accrual  method  used,  495 

asset,  581-599 

auditor's  responsibility  for  prior  date,  495 

bank  account,  verification  of,  502-509 

cash  discounts,  523 

cash  payments,  512 

cash  receipts,  509-512 

certified  bills  as  evidence,  540 

cheques  received,  501 

choice  of,  and  balance  sheet,  55 

collections  not  accounted  for,  518,  524- 
528 

compared  to  balance  sheet  audit,  491 

completed  audit,  491 

continuous  audit,  491 

credit  for  allowances  and  returns,  S53-556 

discount  for  prepayment,  532 

expenditures,  verification  of,  538-577 

footings  and  postings,  496 

fraud  connected  with  receipts,  51S 

general  principles,  491-514 

income, 

from  corporation's  own  securities,  536 
from  investments,  528-532 
verification  of,  515-537 

interest  receivable,  529 

interim  reports,  492 

investments,  income  from,  528-532 

liabilities,  581-599 

manipulation  of  accounts,  492 

memorandum  books  examined,  516 

notes  payable,  593 

original  records  compared  with  final,  516 

payments,  verification  of,  538-577 

petty  cash,  546 

purchase  records,  498 

purchases,  541-546 

realizations  from  items  previously  charged 
to  income,  534 

rents  receivable,  530 

repairs  and  renewals,  551 

sale  of  building  lots,  535 

sales  records,  499 

sales,  verification  of,  516-528 

services  and  other  charges  billed  in  ad- 
vance, 536 


Detailed  Audit — Continued 

subdivision    of   time   to   kinds   of   work, 

497 
trial  balance,  578-581 

forced,  498 
vouchers,  verification  of,  S38-551 
wages  and  salaries,  556-563 
when- should  be  made,  56 
Development  Work, 

expenses  for,  575 
Dickinson,  Sir  A.  Lowes, 
income  account  form,  407 
on  reorganization,  468 
Directors  of  Corporations, 

cannot  confer  unlimited  rights  on  auditor, 

669 
dealings  with  company,  665 
liabilities  of,  214,  665-677 
right  to  inspect  books,  667-669 
salaries  and  compensation,  667 
Discount, 

acceptances,  257 
bond,  573,  583 
cash, 

allowance  for,  332 

in  inventory,  164 

on  capital  payments,  587 

reserves  for,  90 

treatment  of,  532 

verification  of,  523 
classes  of,  532 

deducted  from  bank  balance,  563 
liabilities  for,  231 
notes  payable,  234 
notes  receivable,  109,  250 
trade, 

allowance  for,  331 

treatment  of,  533 
"Discount"  Companies, 

purchase  of  accounts  receivable,  80 
Dividends, 

American  Malting  Company,  294 

audit  of,  595 

Conyngton  on,  293 

English  Companies  Act,  294 

from  net  income,  333 

Interborough-  Metropolitan        Company, 

294 
legal  decisions  of  net  income,  305 
net  income  distributed  in,  295 
New  York  Corporation  Law,  293 
not  paid  from  capital,  292 
paid  out  of  revenue  profits,  322 
preferred  stock,  595 
reserves  for,  288 
stock,  277,  596 
unclaimed,  246 


7i8 


INDEX 


Doing  Business, 

cost  of,  deducted  from  net  income,  324 
Drawings,     Designs,    Etc.,    Valuation, 

189 
Dun,  R.  G.  &  Company, 

statement  form,  402-404 


E 


Earnings    (See    also    "Income    account," 
"  Revenue  profits") 

current, 

items  not  included  as,  458 
East  Grand  Forks  v.  Steele,   Decision 
on  Legal  Responsibility  of  Auditor, 
II 
Economies  Investigated,  452 
Efficiency  of  Organization,  620 
Electrotypes,  Valuation  of,  190 
Embezzlements,  459,  486 

cannot     be     found     by     verification     of 
vouchers  alone,  57 

discovered  by  use  of  charts,  416 

losses  due  to,  as  contingent  liabilities,  248 
Employees, 

accounts  receivable  from,  99 

bonding  of,  35.  459.  557 

records,  66 

vacations,  67 

wages    should    be    paid    in    presence    of 
witnesses,  67 
England,  Legal  Requirements, 

for  reports  in,  420 
Equipment, 

depreciation  for,  647 

depreciation  tables,  648,  649 

valuation,  185 
Erasures  in  Books  of   Account,  603 
Errors, 

causes  of,  479 

clerical,  24 

detection  of,  23-28,  463 

of  commission,  26 

of  omission,  25 

of  principle,  23,  482 

offsetting,  27 
Estates,  Dividends  of,  275 
Estimates, 

auditor's  liability  in  making,  435,  449 

use  of,  in  figuring  profit,  316 
Ethics, 

for  auditors,  9-17 

mii^eading  advertisements,  419 

removal  of  auditor  for  another  not  usual, 
54 

restrictions  on  use  of  reports,  418 

rules  for,  in  U.  S.,  15 


Ethics — Continued 

rules  of  American   Institute   of  accoun- 
tants, 12 

rules  of,  Institute  of  Chartered  Accoun- 
tants, 14 
Examinations  (See  "Investigations") 
Excess  Profits  Tax, 

as  a  factor  in  preparing  correct  balance 
sheet,  31 

Treasury  ruling  on  instalment  accounts, 
103 
Expansion    of     Business     Necessitates 

Credit,  470 
Expenditures  (See  also  "Purchases") 

capital,  58s 

construction  costs,  588 

improvements  and  extensions,  590 

machinery,  592 

maintenance  and  construction  accounts, 
586 

partners'  withdrawals,  594 

real  estate,  588 

repairs  and  renewals,  551 

salaries  account,  592 
Expenses, 

advertising,  576 

allocation  of,  569 

collection  charges,  563 

credit  for  allowances  and  returns,  553-556 

current, 

as  current  assets,  iis 

customs  duties,  563 

decreases  in,  445-449 

deferred  charges,  569-577 

depreciation  considered  as,  634 

experimental  and  development  work,  575 

freight  and  express,  566 

insurance  premiums,  564 

interest  charges,  563 

legal  and  "graft,"  568 

organization,  174.  57^ 

postage,  566 

purchases,  verification  of,  538-551 

salesmen's,  559 

verification  of,  in  detailed  audit,  538-577 

wages  and  salaries,  556-563 
Experimental  Work,  Expenses  for,  S7S 
Export  Sales,  Collection  of  Accounts 

IN,  104 
Express  Expenses,  566 


F 


Failures  (See  "Bankruptcy") 
Federal  Reserve  Board, 

audit  program  for  balance  sheet  method, 
61,  72 


INDEX 


719 


Federal  Reserve  Board — Continued 
financial  statement,  386-392 
inventory  recommendations,  135 
proposal  for  uniform  accounting,  679-705 
Federal     Trade     Commission     Inquiry 

Blank,  358 
Fees,  43-46.  242 
Fictitious  Accounts,  100 
Files, 

for  working  papers,  so 
indexing  scheme  for,  51 
systems,  613 
Financial  Statements, 
bank  requirements,  377 
Federal  Trade  Commission  requirements, 

358 
forms, 

American    Bankers'   Association,    378- 

380 
Bradstreet  Company,  398-401 
Dun,  R.  G.  and  Company,  402-404 
Federal  Reserve  Board,  386-392 
Irving  National  Bank,  381-385 
National  Association   of   Credit    Men, 
394-397 
investigation  of,  470-490 

(for   full   entries   see    "Investigations, 
credit  extension") 
required  by  banks,  377,  470-473 
required  by  credit  managers,  393.  477 
value  of  audit  for  ascertaining  true  condi- 
tion of  affairs,  30 
Finished  Goods, 

inventory  valuations,  142,  170 
profit  from,  314 
Finney,  H.  A.,  quoted,  69,  99 
Fire  Loss, 

advantages  of  an  auditinadjustmentof,3S 
collection  of,  300 
not  insured,  459 
Fixed  Assets  (See  "Assets,  Fixed") 
Fixed  Percentage  Basis  for  Deprecia- 
tion, 627 
Fixed  Percentage  Basis  for  Profit,  316 
Fixtures, 

depreciation  for,  649 
valuation,  187,  467 
Floy,  Henry,  on  Depreciation,  625 
Footings, 

verification  of,  496 
Forecasts,  Auditor's  Liability  in  Mak- 
ing, 435,  449 
Foreign  Branches,  Control  of,  69-70 
Foreign  Exchange,  104 

factor  in  foreign  branch  accounts,  69 
Foreign  Sales, 

collection  of  accounts.  104 


Forgery,  428,  489 
Fraud, 

bank  accounts,  502-509 

cash  discounts,  523 

cash  payments,  512 

cash  receipts,  509-512 

detection  of,  21,  482,  486-490 

fictitious  accounts  receivable,  100 

forgery,  428 

inflation  of  sales,  442 

inventory  understatement,  123 

marking  of  falsified  entries,  428 

methods  of  defalcation,  Si5 

purchases,  543-546 

through  false  postings  and  footings,  496 

under  or  over- valuation  of  assets,  21^-220 

unrecorded  notes  payable,  594 
Freight, 

allowance  for  liabilities,  242 

charges  in  inventory,  164 

expenses,  566 
Funds  (See  "Sinking  funds,"  "Reserves") 
Furniture, 

depreciation  for,  649 

valuation,  187 
Future  Delivery, 

cancellation  of  orders,  261,  312,  319 

contingent  liabilities,  259 

deferred  charges  to  operation,  522 

incopie  from  sales,  319.  5^9.  52i 


Gas,  Bills  Payable,  241 
Good-Will, 

depreciation,  652 

earning  power  of,  195 

International  Harvester  Company,  198 

valuation,  195-200 

chart  for  computing,  199 
formula  for  determining,  197 
Goods, 
finished, 

inventory  of,  142,  170 
in  process, 

inventory  of,  169 
on  consignment, 
in  inventory,  164 
receipt  of,  232 
Graft,  568 

Graphic  Charts,  410-417 
Gross  Income, 

appraisal  of  net  value,  268 

deductions  from,  311-314 

defined,  299 

on  balance  sheet,  311 

returned  goods  deducted  from,  311 


720 


INDEX 


Gross  Income — Continued 
verification  of, 

on  investigation,  438 
Guaranty,  Indorsement  for, 


2SS 


Holding  Companies, 

amounts  due  from  affiliated  companies, 
97-99 

consolidated  balance  sheet,  337-347 

consolidated  income  account,  347-351 

rediscounts,  339 
Home    Office    Control    Over    Branch, 

67-70 
Honesty  in  Business,  471,  483 
Horses, 

depreciation  for,  650 

valuation,  188 
Hypothecations  (See  "Liens") 


Improvements,  586,  590 
Income   (See  *' Gross  income,"   "Net  in- 
come") 
Income  Account, 

advances  and   deposits  collected   in  ad- 
vance, 522 

allowance  for, 

depreciation,  326-328 
obsolescence,  329 

analysis  of,  on  investigations,  438-449 

anticipated  profits,  315 

apportionment  of,  in  liquidating  partner- 
ships, 466 

bad  debts,  313 

cancellation  of  orders,  311 

capital  profits  vs.  revenue,  309 

cash  discounts,  523 

cash  receipts,  S09-S12 

collections  not  accounted  for,  518,  524- 
528 

comparative  statement,  440 

complete  investigation  of  all  sources,  515 

completed   vs.   incompleted  transactions, 
314 

consignments,  312,  519-521 

consolidated,  347-351 

contributed  surplus,  295 

deductions  from  gross  income,  311-314 

detailed  audit,  494-537 

discounts,  331 

discounts  for  prepayment,  532 

dividends, 

not  paid  from  capital,  292 

of  estates,  295 

of  mining  company,  295 


Income  Account — Continued 
effecting  good-will,  195 
expenses,  309,  324 
expenses  accrued,  330 
fire  losses,  300 
form  of,  291,  406-409 

American  Institute  of  Accountants,  408 

Dickinson,  407 
importance  of,  303 

includes  transactions  for  given  period,  495 
interest  should  not  be  paid  out  of  reserves, 

409 
investments,  528-532 

corporation's  own  securities,  536 
losses,  324 
net    income,    300-310    (See    also    "Net 

income") 
order  for  future  delivery,  319,  519,  521 
profits  on  fluctuations,  445 
reading  of,  297 
realizations  from  items  previously  charged 

to  income,  534 
rentals,  S30 
revenues,    311-323    (See  also  "  Revenue 

profits") 
sale  of  building  lots,  535 
sale  of  treasury  stock,  292 
sales,  verification  of,  442,  516-528 
subscriptions  or  sale  of  regular  services, 

536 
terminology  in,  296 
turnover,  calculation  of,  444 
variations  in  arriving  at  conclusions  of, 

303 
verification  of, 

by  use  of  balance  sheet,  518 

in  balance  sheet  audit,  290-334 

in  detailed  audit,  515-537 
Indorsements, 
acceptances,  256 

accommodation,  as  liabilities,  251-2SS 
bank  cheques,  examination  of,  506 
careless  commitment,  253 
guarantees  suretyship,  255 
notes  payable,  594 
secured,  252 
Inflation,  Effect  on  Inventories,  124 
Instalment  Account,  102 
contracts  in  progress,  590 
new  machinery  purchased,  592 
sale  of  building  lots,  535 
stock  sold  on,  274 
Treasury  Department  ruling,  103 
Institute   of    Chartered  Accountants, 

Rules,  14 
Insurance, 
business,  113 


INDEX 


721 


Insurance — Con  tinned 
charges  in  inventory,  164 
fire,  on  furniture  and  fixtures,  187 
investigation  of,  481 
losses  through  lack  of,  459 
on  consignments,  520 
policies  guide  to  clear  titles,  79 
premiums  on,  241 

profit  from,  not  current  earnings,  458 
verification  of  payments,  564 
Integrity,  471 
Interborough-Metropolitan     Company, 

294 
Interest,  655-664 
compound,  657 

from  reserves,  not  good  practice,  409 
not  an  element  of  cost,  155-158 
on  accounts  in  arrears,  656 
on  bank  balances,  verification  of,  563 
on  bonds  and  mortgages,  663 
on  money  borrowed  for  construction  cost, 

589 
payable,  235,  239 
principal,  655 
rate,  657 

notes  receivable,  532 

on  securities,  531 
receivable,  529 

bank  deposits,  457.  530 
time  of  running,  658-662 

bank  customs,  658 

commercial  customs,  650 

New  York  Clearing  House  customs,  661 

New  York   Stock   Exchange   customs, 
661 

stock-brokers  customs,  660 

unit  period,  662 

United  States  Treasury  rulings,  661 
INTERIM  Reports,  492 
Internal    Check    System    (See    "Check 

system,  internal") 
International      Harvester      Company, 

Good-Will,  198 
Inventory, 

accounts  receivable,  120 

calculations  and  footings,  verification  of, 

167 
cash  discounts,  164 
comparison     of    inventory    prices    with 

current  purchases,  164 
conversion  period,  153 
cost  of  goods,  135-144 
detailed  audit  of,  582 
duty  charges,  164 
effect   of  abnormal   conditions  on,    117- 

122 
excessive  valuations,  216 
VOL  I. — 46 


Inventory — Continued 

Federal    Reserve    Board's    recommenda- 
tions, 135 
finished  goods,  142,  170 
fire  loss,  35 
freight  charges,  164 
goods  in  process,  169-170 
goods  sold  vs.  goods  unsold,  160 
in  figuring  turnover,  444 
insurance  charges,  164 
intercompany        or        interdepartmental 

profits  eliminated  from,  152 
interest  not  an  element  of  cost,  155-158 
"inventory  at  cost,"  defined,  134 
legal  duties  of  auditors  concerning,  154 
mark  up,  617 
methods  of  valuation, 

"base"  stock  methods,  124,   125 

basis  of  valuation  should  be  disclosed, 
124 

cost  finding,  135-144 

cost  or  market,  122,  126-131,  159 

cost    segregated     from     increment     in 
value,  166 

discussion,  122-150 

evolution  of  rules,  133 

in  a  falling  market,  141-144 

influences  of  trade  conditions  on,  152 

less  than  cost,  124 

prices  after  closing  date,  150-152 

prior  to  1917.  I34 

reduced  to  replacement  costs,  142 

selling  price,  147-150 

stock  not  converted  into  cash  within 
one  year,  153 

uniform  practice  in,  139 

variations  in,  132 

writing  up  values,  American    Malting 
Company  case,  146 
perpetual,  67 

branch  office,  68 
physical  compared  with  book  entries,  163 
purchases  to  fill  outstanding  orders,  168 
raw  material,  124,  125,  137,  168 
reserves  for,  120,  125,  129 
revaluations  as  of  March  i,  1913.  140 
securities,  iii 
segregation     of     stock     not     convertible 

within  one  year,  153 
sheets, 

inspection  of,  165 

original,  to  be  verified,  162 

used  by  auditor,  62 
stock-taking,  verification  of,  162 
stores  system,  615 
supplies,  stores,  etc.,  172 
Treasury  rulings,  121 


722 


INDEX 


Inventory — Continued 

understatement  of  values,  123 

value  at  date  of  balance  sheet,  126 

value  not  cost  the  criterion,  144 

valuation  liquidating  partnership,  466 

valuations  during  19 19  and  1920,  1 29-131 

verification  of,  162-169,  448 

when  market  price  is  higher  than  cost, 

144-147 
when  reproduction   cost   is   higher   than 

replacement  cost,  141-144 
Investigations      (See      also       "Audits"; 

"Reports") 
assets,  valuation  of,  426 
bank  loans  to  be  repaid,  473 
bankruptcy,  473-476 

causes  of,  478-481 
based  on  definite  facts,  427 
collateral  vs.  integrity,  47 1 
compared  to  audit,  423 
credit  extension,  470-490 

auditors  vs.  credit  managers,  477 

for  bankers,  470-473 

inaccuracies    on    financial    statements, 
479 

insurance,  481 

judging  a  good  risk,  481 

lack  of  capital,  480 

National  Association  of  Credit   Men's 
rules,  478 

procedure  of  credit  manager  and  audi- 
tor, 476 
credit  manager  vs.  auditor,  477 
criticisms     should      be     avoided     when 

making,  455 
data  on  future  business,  472 
defined,  423 

details  which  may  be  omitted,  426 
errors  of  principle,  482 
forecasts,  liability  for  making,  435 
fraud,  482,  486-490 
handling  books  and  records,  427 
into  method  of  doing  business,  479 
patent  litigation,  484 
personal  element,  471,  483 
public  service  corporations,  463 
reorganizations,  468 
sale  of  business, 

accounts  from   books  or  special  com- 
pilations, 436 

accounts  receivable,  466 

adjustments  and  qualifications,  460 

advertising  and  deferred  charges,  446 

analysis  not  audit  is  required  for,  437 

apportionment  of  profits  and  losses,  467 

capital  requirements,  450 

competition  as  an  element,  454 


Investigations — Continued 
sale  of  business — Continued 

damages,  condemnations,  etc.,  458 

deferred  charges,  446 

earnings  and  expenses,  438-449 

earnings  of  future  net  income,  457 

economies  offset  to  pay  for  extrava- 
gences,  452 

elimination  of  unusual  items,  456 

embezzlements,  459 

errors  in  books,  463 

expenses,  446 

extraordinary  items,  456 

fire  and  other  losses  not  insured,  459 

forecasts  or  probable  estimates,  449 

fraud  in  sales,  442 

future  contracts,  461 

good  management,  453 

gross  income,  438 

income  from  assets  not  taken  over,  457 

interest  on  deposits,  457 

insurance  profit,  458 

inventories,  448 

lawsuits,  460 

leases,  447 

liquidating  partnerships,  465-468 

machinery  and  fixtures,  467 

new  accounting  system,  455 

net  income,  439 

old  accounting  system,  455 

partners'  salaries,  460 

period  after  closing  date,  444 

period  covered,  437 

personal  element  in,  453 

profits  on  fluctuations,  445 

public  service  corporations,  463 

requirements,  433 

requirements,  future,  449 

reserves,  excessive,  458 

royalties,  462 

sale  of  assets,  457 

sales,  442 

special  losses  or  expenses,  458 

stock-in-trade,  466 

taxes,  462 

test  required,  464 

turnover  calculation  of,  444 

valuations  variations  in,  434 
statistics,  use  of  to  auditor,  435 
use  of  previous  audits  in,  426 
working  papers,  425 
Investments, 

bonds  secured  by  mortgages,  205 

depreciation  reserves,  636 

effect  of  market  price  on  surplus  funds. 

203 
income  from,  528-532 


INDEX 


723 


Investments — Continued 

low  interest  bearing  securities,  531 

of  funds,  203 

of  reserves,  202 

of  surplus,  289 

permanent,  203 

securities  are  fixed  assets,  iii 

temporary,  114 
Invoices, 

duplicate,  64 

payment  of,  65 

purchases,  verification,  64,  S4i~546 

register,  65 

sales,  internal  check,  66 

suppressed,  229 

verification  of,  in  inventory,  164 
Irish  Woolen   Co.   Ltd.,   v.   Tyson   and 

Others,  545 
Irving  National  Bank,  Financial  State- 
ment, 382-385 


Journal  Vouchers,  Verification  of,  549 
Judgments  Awarded,    Included   in  Bal- 
ance Sheet,  213.  238 


K 


Kingston  Cotton  Mill  Company,  165 


Land. 

depreciation,  638,  643 

sale  of  building  lots,  535 

valuation,  181-182 
Law  (See  also  "Decisions") 

auditor  as  witness,  428-432 

auditor's  duties  as  to  inventories,  154 

decisions  concerning  auditors,  7-17 

fixing  legal  status  of  client  before  work  is 
commenced,  39 

negligence  of  auditor  to  discover  fraud  in 
purchases,  545 

negotiable  instruments,  235 

net  income,  305 

patent  litigations,  484 

rights  of  auditors  under,  7 

trend  of  legal  decisions,  7 
Lawsuits,  Expenses  for,  460 
Lawyer,  Advertising  by.  Not  Ethical, 

Decision,  15 
Leake,  P,  D.,  on  Depreciation,  691 
Leaseholds, 

annuity  system  of  writing  off,  646 

cash  deposit  as  security  under,  106 

depreciation,  646 


Leaseholds — Continued 
investigation  of,  447 
landlord's  fixtures,  depreciation  for,  650 
valuation,  183 
Ledger, 

balancing  of,  617 
columnar,  619 

individual,  not  accessible  to  cashier,  63 
subsidiary,  controlling,  619 
verification  by  tests  and  scrutiny,  497 
Legal  Expenses,  2^2,  460,  568 
Liabilities, 

accounts  payable,  225 

audit  fees,  242 

auditors,  7.  73 

bonds  issued,  236 

commissions,  242 

concealment  and  deception  of,  233 

consignments,  goods  received  on,  232 

contingent,  247-266 

acceptances,  256-258 

banks,  259 

bond,  note  and  stock  stipulations,  as 
effecting,  263 

capital  stock  converted  into  bonds,  259 

classification  of,  248 

defined,  247 

commitments  leading  to  entanglements, 
253 

contracts  for  future  delivery,  259-263 

created  after  date  of  balance  sheet,  249 

guaranteeship,  255 

indorsements,  251-259 

listed  on  balance  sheet,  371 

litigations,  248 

losses  due  to  default,  248 

minute  book  as  source  of  information 
for,  264 

notes    receivable    discounted    as    bad 
debts,  250 

points  involved  in,  264-266 

provision  for,  54 

suretyship,  255 

unrecorded,  258 
coupons,  unused  tickets,  244 
damages,  243 

deposits  other  than  bank,  244 
detailed  audit,  58i-S99 
determination  of,  222 
directors',  665-677 
discounted  notes  payable,  234 
discounts,  231 
distinct  from  capital,  223 
distinct  from  net  worth,  269 
dividends,  unclaimed,  246 
employees'  profit-sharing  plans,  243 
freight  allowance  for,  242 


724 


INDEX 


Liabilities — Continued 
interest  payable,  239 
interest  rate  on,  23s 
investigation  of,  80 
invoices  suppressed,  229 
irregular  items,  229 
items  omitted,  228 
judgment  payable,  213,  238 
legal  expenses,  242 
listed    on    consolidated    balance    sheet, 

341 
loans  payable,  237 
mortgages  payable,  23s 
notes  payable,  233-23S 
of  client  in  making  audit,  39 
order  and  receiving  books  inspected,  230 
premiums  on  insurance,  241 
ratio  of  current  assets  to,  82 
rent  payable,  241 
subordinated  debts,  224 
taxes  payable,  239 
tests  for  verifying,  230 
trade  creditors,  228 
traveling  expenses,  242 
wages,  accrued,  241 
water  and  gas  bills,  payable,  241 
Liberty  Bonds,  Valuation,  112 
Liens,  79 

on  cash  in  bank,  86 
on  income  account,  405 
on  real  estate,  180 
trust  receipts,  80 
Liquidating  Partnerships,  465-468 
Litigations  as  Contingent  Liabilities, 

248 
Loans, 
bank, 

certified  accounts  to  secure,  endorsed, 
34 

investigation  to  secure,  470-473 

to  be  repaid,  413 

value  of  audit  for,  33 

verification  of  interest  charges  on,  563 
interest  time  on,  658 
liens,  79 

on  accounts  receivable,  79 
rules  governing,  237 
Location   of  Industry.  Importance  of, 

448 
Losses, 

arising  from  future  contracts,  260 

not  insured,  459 

of  subsidiary  companies,  351 

reserves  for,  461 

transactions    out    of    which    they    may 

occur,  248 
Lumber  (See  "Timber") 


M 


Machinery, 

depreciation  for,  047 

purchases  of,  592 

valuation,  185,  467 
Mail, 

handling  of,  615 

incoming, 

cash  remittances  should  be  listed,  63 
internal  check,  63 
Maintenance, 

charged  against  income,  S5i.  586 

depreciation  for,  625,  647 
Majority    Interests    on    Consolidated 

Balance  Sheet,  343 
Management,  Essential  of  Good,  32,  453 
Manipulation  of  Accounts,  492 
Mark  Up,  617 
Market  Price,  142 
Market  Value, 

defined,  74 

or  cost,  126-131,  158 
Marks  on  Books  and  Records,  427 
Mechanical  Devices,  604-613 
Memorandum  Books,  Examination  of,  516 
Mines, 

depreciation,  653 

valuation,  212 
Mining  Company,  Dividends  from  Net 

Income,  29s 
Minority    Interest    on    Consolidated 

Balance  Sheet,  341 
Minutes,  Books  of,  264,  665 
Misappropriation,  490 
Mortgages, 

bonds  secured  by,  205 

interest  on,  calculation  of,  663 

payable,  235 
MusER  V.  Magone,  131 


N 


National  Association  of  Credit  Men, 
on  granting  of  credit,  478 
statement  form,  394-397 
Negligence, 

auditor,  court  decision,  1 1 

claim    for,    recovered    by    means    of    an 

audit,  38 
Irish  Woolen  Mill  Co.  Ltd.,  v.  Tyson  and 

others,  545 
Kingston  Cotton  Mills  Company,  165 
of  bank  depositor,  SOS 
of  banks,  507 

writing  up  values  (Hutchinson  v.  Curtiss), 
146 


INDEX 


725 


Net  Earnings,  Use  of  Term,  2Q7 
Net  Income,  268 

as  affected  by  partners'  salaries,  461 

blue-sky  laws,  302 

deductions  for  taxes  included,  301 

deductions     from,     for     cost     of     doing 
business,  324 

defined,  300,  309.  406 
by  accountants,  308 
economically,  308 
legally,  305 

dividends  from,  333 

future  earnings,  457 

legal  decisions  over,  306-308 

relation  to  price-fixing,  304 

surplus  from,  333 

treatment  of,  302 

verification  of,  in  investigation,  439 
Net  Profits,  Use  of  Term,  297 
Net  Worth,  Distinct  from  Liabilities, 

269 
New  York   Clearing  House,   Interest 

Time  Calculation,  661 
New  York  Public  Service  Commission, 

628 
New  York  Stock  Corporation  Law,  293 
New  York  Stock  Exchange,   Interest 

Time  Calculation,  661 
Nominal     Accounts,     Verification     of 

Postings,  511 
No-Par  Value  Stock,  208,  274-277 

on  balance  sheet,  374 
Notes  Payable,  233-235 

detailed  audit,  593 

discounted,  234 

indorsements,  594 

schedule  of,  62 

unrecorded,  594 
Notes  Receivable,  107-116,  582 

accommodation  indorsements,  251-255 

as  bad  debts,  250 

customs  of  trade,  107 

demand  notes,  108 

discounting  of,  109,  250 

exammation  of,  107 

interest  accrued,  no 

interest  rate  on,  532 

out  for  collection,  107 

overdue  payment  on,  108 

partial  payments  on,  108 

protested,  108,  582 

schedule  of,  62 

segregation     of     items     not     collectible 
within  reasonable  time,  100 

trade  acceptances  not,  109 

trade  accounts,  107 

unmatured  notes  only,  included  as,  108 


Notes  Receivable — Continued 

unpaid  subscriptions  on  capital  stock  not, 

no 
valuation,  107 


Obsolescence, 

allowance  for,  on  income  account,  329 

machinery  and  equipment,  186 

provisions  for,  637 
Office  Management,  600-620 

books  and  records  used,  602 

copying,  615 

filing  systems,  613 

for  making  audit,  46 

mailing  department,  615 

mechanical  devices,  604-613 
Officers  of   Companies,   Accounts  Re- 
ceivable from,  99 
Orders, 

sales,  verification  of,  517 

valuation  of  materials  purchased  speci- 
fically for,  137 
Organization  Expenses,  576 

not  fixed  assets,  174 
Overdrafts,  not  Deducted  from  Bank 

Balances,  89 
Overvaluation,  215-217 


Paper,  Required  for  Audit,  48 
Par  Value,  Stock,  207 
Partnerships, 

advantages  of  audits  to,  34 
liabilities  between  partners,  225 
liquidating,  465 

accounts  receivable,  466 
apportionment  of  profits  and  losses,  467 
valuation   of  machinery  and   fixtures, 

467 
valuation  of  stock  on  hand,  466 
partners'  salaries,  460 
partners'  withdrawal  of  funds,  594 
Pass-Books,  86 
Patents, 

cash  value,  192 
depreciation,  652 
expenses  over  litigation,  191 
investigation  of  litigation,  484 
revaluations,  192 
royalties,  462 

Treasury  Department  ruling,  192 
valuation,  190-193 
Patterns,  Valuation,  189 
Payments   (See  "  Cash  payments,"   "  Ex- 
penses," "  Expenditures  ") 


726 


INDEX 


Pay-roll, 

accrued  wages,  241 
internal  check,  66 
signing  of,  67 
verification  of,  556-563 
Personal  Element, 

towards  stability  of  a  business,  471,  483 
towards  success  of  a  business,  453 
Petty  Cash  Fund, 
branch  office,  68 
verification,  63,  87,  S48 
vouchers  for  disbursements  from,  63,  546, 

548 
Plant  Records,  Analysis  of,  175-177 
Postage  Stamps,  115,  566 
Postings, 

cash  discounts,  523 
cash  payments,  5x3 

customers'  accounts,  verification  of,  511 
nominal  account,  verification  of,  511 
purchase  records,  498 
sales  records,  499 
verification  of,  496 
Price  Fixing,  304 
Prices, 

after  closing  date  of  balance  sheet,  151 

during  1919  and  1920,  129-131 

effect  of  fluctuating  on  ^inventories,  126- 

131 
market,  142 
replacement,  142 
sales,  142 
Procedure, 

accounts  receivable,  62 

American      Institute      of      Accountant's 

memorandum  on,  61 
bank  cheques,  arrangement  of  vouchers,  62 
controlling  accounts,  reconcilement  with 

subsidiary  records,  61 
Federal  Reserve  Board,  recommendations 

of,  61 
inventory,  162-169 
inventory  sheets,  62 
notes  payable,  62  ^  , 

notes  receivable,  62 
preliminary, 

arrangement  of  working  papers,  47 

authority  for  making  audit  determined 
before  starting  audit,  39 

choice  of  method,  55 

co-operation  with  client  and  staff,  41 

familiarity  with  system  in  use,  52 

fees,  43-46 

fixing  responsibility  for  audit,  39 

limitations     of     balance     sheet     audit 
understood  by  client,  72 

mapping  out  program,  40 


Procedure — Continued 
preliminary — Continued 
office  arrangement,  46 
place  of  making  audit,  46 
provision  for  contingent  liabilities,  54 
schedule  of  books,  records  and  names 

of  clerks,  53 
stationery  needed,  48 
when  supplanting  another  auditor,  4 
statements  from  creditors,  62 
trial  balance,  61 
Production  Method  for  Depreciation, 

631 
Professional  Ethics  (See  "Ethics") 
Profits  (See    also    "Capital";    "Revenue 
profits") 
earned, 

items    segregated    from    unearned    in 

inventory  valuation,  160 
only  on  delivery  of  sales  contract,  170, 

S2I 

extraordinary  not  earnings,  457 

from  insurance  not  current  earnings,  458 

from  sale  of  capital  assets,  280 

insurance,  459 

interdepartmental  or  intercompany,  152 

methods  of  figuring  on  stock,  617 

not  an  element  of  cost,  171 

on  construction  work,  589 

on    orders    filled    after   closing    date    of 

balance  sheet,  151 
undivided  is  earned  surplus,  280 
unearned, 

valuation  of,  in  inventory,  149,  160 
(Hutchinson  v.  Curtiss),  146 
Profit  and  Loss  Statement  (See  also  "In- 
come account") 
defined,  405 
Profit-Sharing  Employees,  Net  Amounts 

AS  Liabilities,  243 
Program  (See  also  "Procedure") 

value  of,  60 
Proof-Sheet,  619 

Public  Service  Corporations,  Investiga- 
tions OF,  463 
Publicity  of  Corporation  Reports,  37 
Purchases  (See  also  "Accounts  payable"; 
"  Commitments  " ;  "  Expenditures  ") 
accounts  payable  on  balance  sheet  audit, 

228-231 
comparison  of  invoice  with  goods  received, 

65 
internal  check  for,  64 
invoices, 

department  store  methods-  65 
verification  of,  541-546 
verification  of,  in  inventory,  164 


INDEX 


727 


Purchases — Continued 

of  a  business,  investigation  for,  432-469 

order    and    receiving    books    inspected, 
230 

payment  for,  65 

received,  checking  system,  64 

records,  verification  of,  498 

verification  of  items,  538-SSi 
Purchasing     Department,     Tests     for 
Examination  of,  542 


R 


Rate- Making,  Public  Construction.  590 
Raw   Materials  Inventory  Valuation, 

124,  125,  137,  167 
Real  Estate, 

as  security  for  bonds,  205 

classification  of,  180 

depreciation,  638,  643 

liens  on,  180 

purchases  of,  588 

rents  receivable,  S30 

sale  of  building  lots,  535 

title  to,  180 

valuation,  179-184 
Receipts     (See     "Accounts     receivable"; 

"Income  account") 
Records, 

auditor  should  secure  a  list  of  all  used,  515 

original,  604 

compared  with  final,  516 

titles  of,  should  be  distinctive,  514 
Rediscounts,  339 
Rent,  447 

payable,  241 

receivable,  530 

R  30RGANIZATI0NS, 

investigations  for,  468 

new  system  of  accounts  for,  455 
Repairs, 

depreciation  for,  625,  647 

in  book  value  of  property,  178 

verification  of,  551 
Replacements, 

cost  of,  142 

in  book  values  of  property,  178 

verification  of,  55 1 
Reports,  (See  also  "Investigations") 
Forms,  354-357 

"as  of"  date  of  balance  sheet,  364 

auditor's  liability  for,  359 

balance  sheet,  forms  of,  365-381 

certificates  of  audit,  360-365 

compulsory,  420 

Federal      Trade      Commission      inquiry 
blank,  3S8 


Reports — Continued 
graphic  charts,  410-417 
income  account,  406-409 
information  for  banker,  353 
information  on,  should  be  of  real  value, 

353 
legal     requirements     in     England     and 

Canada,  420 
liability  of  auditor  for,  359 
liens,  provisions  for,  405 
omissions  from,  417 
precautions  against  separation  of  sheets, 

365 
proper     preparation     and     presentation, 

352 
requirements  of,  359 
scope  of,  359 

tact  used  when  making,  42 
terminology  on,  354 
unauthorized  use  of,  418 
verification  of  items  on,  359 
water  marked  paper,  365 
Requisitions,  Control  of,  64 
Reserves, 

against    accounts    receivable,    sufficiency 

of,  31 
as  assets,  267 
as  liabilities,  267 
balance  sheet  treatment,  269 
classes  of,  267 
excessive,  215,  458 
for  accounts  receivable,  90 
for  accrued  losses,  46 1 
for  bad  debts,  251,  314 
for  cash  discounts,  90,  332 
for  depreciation    (See   "Depreciation  i»' 

serves") 
for  dividends,  288 
for  inventories,  120,  125,  129 
for  retiring  bonds,  notes,  etc.,  286 
for  retirement  of  preferred  stock,  286 
for  taxes,  240 
for  working  capital,  287 
interest  out  of,  not  good  practice,  409 
investments  of,  202 
on  balance  sheet,  267-271 
on  income  account,  324,  409 
procedure,  283 
secret,  214-220,  622 
segregation  of,  269 
surplus,  268 

transferred  to  surplus,  283 
Returned  Goods, 

cancelled  contracts,  312 
credit  for,  verified,  553-555 
deducted  from  gross  income,  311 
record  for  purchases,  65 


728 


INDEX 


Revenue    Profits     (See    also      "Income 
account") 

allowances  and  rebates,  313 

anticipated,  315 

appreciation  in  value  of  assets,  321 

completed   vs.   incompleted   transactions, 
314 

defined,  309 

departmental,  317 

distribution  of,  among  departr-  "tits,  317 

dividends  paid  out  of,  321 

fixed  percentage  basis,  316 

intercompany,  318 

ordinary  transactions  only,  included,  312 

participations  and  underwriting,  320 

returned  goods,  311 

royalties,  321 

sales  for  future  delivery,  319 

sale  of  capital  assets,  320 

use  of  estimates,  316 
Royalties, 

income  from,  321,  462 

payments  for  machinea,  593 
Rules, 

American  Institute  of  Accountants,  12 

Institute  of  Chartered  Accountants,  14 


Salaries, 

directors',  667 

partners',  460 

selection  of  accounts  for,  592 

verification  of,  556-563 
Sales, 

advances  and   deposits  collected   in   ad- 
vance, 522 

advantages  of  audits  in,  37 

cash,  verification  of,  517 

fictitious  or  fraudulent,  442,  512-528 

future  delivery  (See  "Future  delivery") 

invoices, 

check  system  for,  65 
comparison  of,  65 
duplicates,  65 

of  a  business, 

actual  values  in  balance  sheet,  141 
investigations   for,    432-469    (For   full 
entries  see  "Investigations") 

of  capital  assets  not  credited  to  capital 
surplus,  280 

on  consignments,  312,  521 

price,  142 

when  to  value  inventory  at,  147-150 

profits  realized  only  on  delivery  of,  171 

records,  verification  of,  499 

relation  of  outstanding  contracts  to  raw 
materials,  168 


Sales — Continued 

valuation  of  orders  in  decliningmarket,  167 
verification  of,  442,  516-528 
tests  for  falsification,  517 
Salesmen, 

commissions,  559 
expenses,  559 
Scrutiny,  Defined,  493 
Securities^ 

are  fixed  assets,  1 1 1 

as  stock-in-trade,  inventory  of,  11 1 

blue-sky  laws,  302 

income    from    corporation's    own     issue, 

536 
provisions  of,  263 
reserves  for  retiring,  282-287 
Ships,  Depreciation,  651 
Single  Entry  Books,  Audit  of,  52 
Sinking  Funds, 

depletion  aiethod,  211 

examination  of,  200 

for  depreciation,  628-631 

vs.  for  bond  retirement,  632 
for  retiring  bonds,  notes,  etc.,  286 
for  retiring  preferred  stock,  286 
reserves  for,  282-287 

illustration  showing  prociedure,  289 
Statements    (See   also    "Financial    state- 
ments," "Reports") 
customer's, 

not  accessible  to  cashier,  63 
verification  of,  527 
from  creditors,  62 
Stationery  for  Making  Audit,  48 
Statistics,  Use  of,  to  Auditor,  435 
Stock    (See  also  "Capital  stock,"  "Divi 
dends") 
no-par  value,  208,  274-277 

on  balance  sheet,  374 
par  value  of,  207 
preferred, 

dividends  on,  595 
premiums  on  redeemable,  584 
reserve  for  retirement  of,  286 
sold  on  instalment  plan,  274 
treasury,  206-208 
sale  of,  292 
Stock-Brokers, 

interest  time,  660 
Stock  Certificates, 

definitions  and  provisions,  706-708 
examination  of,  597 
Stockholders, 

majority  interests,  343 
minority  interests,  341 
protected  by  audit,  36 
statutory  liability,  213 


INDEX 


729 


Stock-in- Trade  (See  also  "Inventory") 
deterioration  of,  167 
methods  of  keeping,  615 
perpetual  inventory,  67 
pricing,  617 
turnover,  444 

valuation  for  liquidating  partnership,  466 
value  of,  branch  offices,  69 
verification  of  inventory,  162 
Stores     (See      "Inventory,"      "Stock-in- 
trade") 
Subordinated  Debts  on  Balance  Sheet, 

224 
Subscriptions,  536 
Subsidiary  Companies, 
amounts  due  from,  97-99 
consolidated  balance  sheet,  337-347 
consolidated  income  account,  347-35 1 
defined,  337 

intercompany  profits,  318 
liabilities  of,  251 
purchase  of  stock  of,  344 
Supplies,  Inventory  of,  172 
Surety  Bonds  for  Employees,  35,  459,  557 
Suretyship,  Indorsements  for,  255 
Surplus,  268,  278-289 
accounts,  279 
analysis  of,  279 
appropriated,  280,  282 
capital,  279 

when  separated  from  earned,  in  balance 
sheet,  374 
consolidation  of  accounts  not  good  prac- 
tice, 279 
contributed,  are  distributions  of  capital, 

295 
earned,  280 

when  separated  from  capital,  on  balance 
sheet,  374 
from  net  income,  333 
groupings  of,  in  balance  sheet,  280 
investment  of,  289 
nature  of,  279 
not  a  fund,  279 
paid-in,  279.  281 
reserve,  268 

for  dividends,  288,  309 
for  working  capital,  287 
sinking  fund,  282-287 
tax  regulations,  281 
transfer    of    special    reserve    to    general 

surplus,  283 
valuation,  203 


Tact  Required  of  Auditor,  43 
Tangible  Assets  (See  "Assets,  Tangible") 


Tax  Rates,  Balance  Sheet  and,  31 
Taxes, 

accruals  and  reserves  for,  240 

examination  of,  599 

investigation  of,  46a 

payable,  239 

reserves  for,  240,  409 
Terminology,  296-300,  354 
Tests,  Defined,  493 
Third  Avenue  Railway  Co.,   Deprbcia 

TioN  Fund,  628 
Tickets,  Unused,  as  Liabilities,  244 
Timber  Depreciation,  654 
Timber  Land  Valuation,  213 
Tools, 

depreciation  for  ,649 

valuation,  187 
Trade  Accounts, 

notes  receivable,  107 

on  balance  sheet  audit,  228 

overdue,  91-96 
Trade  Discounts,  331 

treatment  of,  532 
Transportation  Charges, 

checking  system  of,  64 

verification  of,  566 
Traveling  Expenses,  242,  559 
Treasury  Stock,  206-208 

sale  of,  292 
Trial  Balance,  61 

as  an  aid  in  verifying  income,  518 

branch  ledger,  68 

detailed  audit,  578-581 

forced,  498 
Trust  Receipts,  80 
Turck,   J.   A.   v.,    "Origin  of   Moder> 

Calculating  Machines,"  613 
Turnover, 

calculation  of,  444 


Undervaluations,  217-219 

Unfinished    Goods       (See       "Work      in 

Progress") 
Uniform  Accounting, 

proposal  of  Federal  Reserve  Board,  679- 
70s 
United  States  Bureau  of  Corporations, 

on  good-will,  198 
United  States  Steel  Corporation, 

reserves  against  falling  prices,  125,  129 
United  States  Treasury, 

interest  time  calculations,  661,  663 

ruling  regarding  instalment  accounts,  103 

ruling  regarding  inventory,  121 

ruling  regarding  patents,  192 


730 


INDEX 


Vacations,  67 
Valuation, 
accounts  receivable,  91 
actual  on  balance  sheet  of  business  for 

sale,  141 
adjustment  of  cost  to  value,  144 
assets,  73 

appreciation  in,  321 

in  making  investigations,  426 

liquidating  partnerships,  465 
automobiles,  189 
book  value  as  actual,  175 
buildings,  179-184 
containers,  187 
copyright,  194 
drawings,  189 
electrotypes,  190 
equipment,  185 
excessive,  215-217 
fixed  assets,  173 
fixtures,  187,  467 
furniture,  187 
good-will,  195-200 
horses,  188 
inventories,  1 17-172  (For  full  entries  see 

"Inventory") 
investments,  202-209 
land, 181-182 
leaseholds,  183 
Liberty  bonds,  112 
machinery,  185.  467 
market  value  defined,  74 
methods   of  arriving   at,    balance   sheet, 

177-179 
mines,  212 
mortgages,  205 
notes  receivable,  607 
patents,  190-193 
patterns,  189 
real  estate,  179-184 

revaluation  as  at  March  i,  1913.  140,  322 
securities,  iii 
stock,  206-209 
stock-in-trade,    liquidating    partnership, 

466 
timber  land,  212 
tools,  187 
undervaluations,  217-219 


Valuation — Continued 

values  as  of  March  i,  1913,  in  computing 

costs,  140 
variations  in,  434 
wagons,  189 
wasting  assets,  209-213 
woodcuts,  190 
Vouchers, 

bank  cheques,  63 

arrangement  of,  62 

use  of,  539 
branch  office,  internal  check  on,  68 
cancellation  of,  5SO 
certified  bills  as,  540 
expense,  verification  of,  538 
for  notes  paid,  593 
former  method  of  auditing,  57 
journal,  549 
missing,  546 
on  reports,  417 
petty  cash  fund,  63,  546,  548 
postage,  566 
purchases,  541-546 


w 


Wages  (See  also  "Pay-rolls") 

accrued,  241 

verification  of,  560 

vouchers,  546 
Wagons, 

depreciation,  650 

valuation,  189 
Wasting  Assets  (See  "Assets,  wasting") 
Water,  Bills  Payable  for,  241 
Water-Marked  Paper  for  Report,  365 
Webster,  George  R.,  on  Consolidatbi 

Accounts,  335 
Witnesses,  Auditors  as,  428-432 
Woodcuts,  Valuation,  190 
Work  in  Progress, 

estimates  on,  316 

profit  from,  314 

when  no  profit  is  included,  316 
Working  Papers, 

arrangement  of,  46 

filing  of,  50 

in  law  cases,  429 

to  be  preserved,  425 


rr^ 


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